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Question:

Everyone is risk neutral and the risk free rate is 0%. Firm A needs to raise $2,000 by issuing a 1- year bond with face value $2,000 and coupon rate c in order to pursue either Safe Project S, or Risky Project R, which would each require an investment of $2,000 at t=0. S will produce $2,500 at t = 1. R will produce either X or 0 at t = 1 with probability 50% for each outcome. The company decides between Sand R after they get the money from bondholders. Bondholders are aware that equity holders will do what is optimal for equity holders.

1. For what value of X would the following be a valid equilibrium solution: the company issues debt with face value 2000 and coupon rate 0% and invests in S.

a) 2,800

b) 3,200

c) 3,500

d) 6,000

e) 7,000

f) None of the above

3) For what value of X could the following be a valid equilibrium solution: the company issues risky debt and invests in R.

a) 2,800

b) 3,200

C) 3500

d)6000

e) All of the above

f) None of the above

10) Now assume that X = 9,000, the company has 100 shares outstanding, and the bond is a 1-year Zero coupon bond with face value $2,000 and convertible into N shares at t = 1 after the outcome of the company’s project. For which value of N is the following an equilibrium solution: the company issues the bond and selects Project S

a) 5

B 6

C 7

D 8

e) All of the above

f) None of the above

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