This question illustrates that when there is scope for the firm to vary its risk, lenders may be more prepared to lend if they are offered a piece of the action through the issue of a convertible bond.

Ms. Blavatsky is proposing to form a new start-up firm with initial assets of $10 million. She can invest this money in one of two projects. Each has the same expected payoff, but one has more risk than the other. The relatively safe project offers a 40 percent chance of a $12.5 million payoff and a 60 percent chance of an $8 million payoff. The risky project offers a 40 percent chance of a $20 million payoff and a 60 percent chance of a $5 million payoff.

Ms. Blavatsky initially proposes to finance the firm by an issue of straight debt with a promised payoff of $7 million. Ms. Blavatsky will receive any remaining payoff. Show the possible payoffs to the lender and to Ms. Blavatsky if

(a) She chooses the safe project and

(b) She chooses the risky project. Which project is Ms. Blavatsky likely to choose? Which will the lender want her to choose?

Suppose now that Ms. Blavatsky offers to make the debt convertible into 50 percent of the value of the firm. Show that in this case the lender receives the same expected payoff from the two projects.