Please just try anything.

Problem 3=[25 Points) Consider the following situation: A firm's equity holders want to raise money to invest by issuing debt. Once they raise the money (i.e., \"after\"), the firm faces a mutually exclusive choice between two projects: Cash Flows Economic State Probability Project 1 Project 2 Recession 20% 50 0 Slow recovery 50% 50 50 Expansion 30% 50 75 Both projects require an investment of 30 {which needs to be raised by issuing debt). Assume that all parties are risk neutral and that the discount rate is zero. The rm is limited liability and has no other assets or projects. a. Which project has the higher NPV (\"first best\")? Assuming debtholders believe that equity holders will invest in this project, what is the required promised payment D to debtholders? By how much does the value of equity change? [7 points] b. Assuming the rm obtains the financing determined in part {a}, what is the optimal decision once the debt is issued. Show all steps. Is this a Nash equilibrium? Explain! [7 points] c. Determine the equilibrium. [6 points] d. What is the dilemma, and what is the source of the inefficiency? who is losing out here? Suggest and briefly discuss two possible solutions that could help mitigate the inefficient outcome (but continue to assume that only debt can be used for financing). [5 points] Problem 4=(25 Points) Please read carefully: There are 2 firms, Firm B ("Bad} and Firm G (\"Good"), that each have $50 in cash but need to borrow an additional $200 in order to nance a one-period investment project. The firms are limited liability corporations and exist for only one period, after which they will be dissolved. You are a loan officer at the Seattle Lemon Bank. The only way for the firms to nance their project is to borrow from your bank. While you are unable to identify the type of firm (B or G), you have the following additional information: o The payoffs of rm B's investment one year from now would be either $1000 with 30% probability or $0 with 70% probability. a The payoff of rm G's investment would be $350 for sure. 0 You can assume that the expected return requirement for any loans you make are zero (i.e., no need to discount payoffs) Once the firm obtains the loan of $200 it must invest the entire 5250 into the project. However, the firm can always opt to not take the loan and thus forgo the investment opportunity, in which case it simply returns the $50 cash in one year. (Note: You may find it useful to sketch out what is going on.) a. Suppose both firms had enough cash to finance the investment of $250, compute the net present values ofthe investment opportunities for firm B and for firm G {you can ignore discounting). Which of the two projects should be undertaken from an NPV perspective? [5 points] b. Now suppose the rms approach your bank. In return for the loan of 5200 today, you require a fixed loan repayment of 5D one period from now (a standard debt contract). While you cannot identify the firm types, first assume that both firms will take your loan offer. What must be the promised repayment $D such that the bankjust breaks even? (Note that because there are only 2 firms, they are equally likely). [5 points] c. Using the promised payment SD you computed in part (b), reanalyze the project opportunity from each firm's perspective (Remember that each firm can choose to forgo the investment opportunity). For each firm type, what are the firm values of doing the project and how does this compare with not doing the project? [5 points] d. Which of the two firms would take the bank's offer [$200 in return for the promised payment of SD you computed in parts (b) and (c)) and what would this mean for the bank's profits? Assuming that the bank must break even, in equilibrium, who will be financed and at what promised amount SD? Explain. [7 points] e. Now suppose that the two firms are run and owned by wealthy, risk-neutral CEOs. While the firms are limited liability corporations, you require the CEOs to personally guarantee any loan you provide to the rm {the CEOs are unwilling to provide direct financing to the firm). Assume that the CEOs have sufficient personal funds at the end of the period to make whole on the loan. How does this personal guarantee affect the information problem? That is, which of the firms will want to contract with your bank and what loan terms are being offered, if any? Explain. [3 points]