On 1/1/2019, Firm XYZ signs a debt contract. According to the debt contract, Firm XYZ raises $100,000 from an investor
On 1/1/2019, Firm XYZ signs a debt contract. According to the debt contract, Firm XYZ raises $100,000 from an investor and promises to pay the investor $100,000 on 1/1/2020 (i.e., the interest rate is zero). On 1/2/2019, Firm XYZ finds that there are two investment opportunities, and each project costs the firm $100,000:
Project 1: $400,000 with probability 0.4 and $0 with probability 0.6
Project 2: $200,000 with probability 1.
i). Which project exhibits a higher NPV?
ii). Which project does the firm prefer? Firm prefers project 1 because
iii). How about debt holders? Debt holders would prefer project 2 because
iv). Suppose that, on 1/1/2019, the investor knows that the firm will choose a project between project 1 and 2. Would the investor choose to sign the debt contract?