QUESTION $1.$ PARTA. $[3$ points$]$ Suppose a company borrows $$1$ million debt to invest in a project that generates uncertain cash flow $($revenue$)$ of $0$$$2$ million. The debt has to be repaid $($interest rate is zero$)$ when the project's cash flow is realized. Clearly mark where the lines start, end and change direction

$1-1.$ Assume $80\%$ of the cash flow $($revenue$)$ is lost upon bankruptcy $($i$.$e$.,$ when debtholders control the firm$).$ Also, assume that renegotiations are allowed and the manager may be allowed to stay if debtholders find it better than firing. Upon renegotiation debt and equity holders have $2$:$3$ bargaining power. Draw value of debt, equity, and the company.

$1-2.$ For Question $2-1,$ at what company cash flow does strategic default start to occur?

$1-3.$ Strategic debt service is an example of $),$ where each party to a contract worries about being forced to accept disadvantageous terms Iater $($e$.$g$.$ reduction of debt repayment through renegotiation$),$ after it has sunk an investment $($e$.$g$.$ lending money$).$ Fill in the blank.

PART B$.[2$ points$]$ For part B$,$ assume $100\%$ of the cash flow is lost upon bankruptcy $($i$.$e$.,$ when debtholders control the firm$).$ Also, assume that renegotiations are allowed and the manager may be allowed to stay if debtholders find it better than firing. Upon renegotiation debt and equity holders have $3$:$2$ bargaining power.

$1-4.$ Draw value of equity.

$1-5.$ Do you expect the company value to be higher or lower than the case considered in PART A$?$

a$.$ higher

b$.$ lower

c$.$ same

d$.$ unknown due to asymmetric bargaining power