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EF4313 Corporate Finance I assignment 2

# EF4313 Corporate Finance I assignment 2 - EF4313 Corporate...

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EF4313 Corporate Finance I Problem Set 2 Student Name and No.: Yeung Kai Fung, 50716538 1 1. A firm has \$100 million in cash on hand and a debt obligation of \$100 million due in the next period. With this cash, it can take on one of two projects – A or B – which cost \$100 million each. Assume that the firm cannot raise any additional outside funds. If the economy is favorable, project A will \$120 million and project B will pay \$101 million. If the economy is unfavorable, project A will pay \$60 million and project B will pay \$101 million. Assume that investors are risk neutral, there are no taxes or direct costs of bankruptcy, the riskless interest rate is zero, and the probability of each state is 0.5. 2 a. What is the NPV of each project? NPV(A) = -\$100 + 0.5*\$120 + 0.5*\$60 = -\$10m NPV(B) = -\$100 + 0.5*\$101 + 0.5*\$101 = \$1m b. Which project will equity holders want the managers to take? Why? Project A Project B Favorable (0.5) Unfavorable (0.5) Favorable (0.5) Unfavorable (0.5) Firms CF 120 60 101 101 Claim of Debt Holder 100 60 100 100 Claim of Equity Holder 20 0 1 1 Expected payoff for Equity holder in Project A = 0.5*20+0.5*0=\$10m Expected payoff for Equity holder in Project B = 0.5*1+0.5*1=\$1m

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EF4313 Corporate Finance I assignment 2 - EF4313 Corporate...

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