A firm has £ 100m cash in hand and a debt obligation of £ 100m due at the end of the year. With this amount of cash, it can take one of two projects, A or B, which cost £ 100m each.  At the end of the year, project A pays £ 120m if the economy is favourable and £ 60m if the economy is unfavourable. In contrast, project B pays £ 101m regardless of the state of the economy. Assume that the firm is not able to raise any additional funds. Further, assume that investors are risk-neutral, there are no taxes and no direct costs of bankruptcy, the risk-free rate of interest is nil, and the probability of each state of the economy is equal. i. What is the NPV of each project? ii. Which project will equity holders want the firm's manager to take? Explain.  iii. Calculate the magnitude of the agency cost of risk shifting.

FINANCIAL ACCOUNTING
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ISBN:9781259964947
Author:Libby
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Chapter1: Financial Statements And Business Decisions
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A firm has £ 100m cash in hand and a debt obligation of £ 100m due at the end of the year. With this amount of cash, it can take one of two projects, A or B, which cost £ 100m each.
 At the end of the year, project A pays £ 120m if the economy is favourable and £ 60m if the economy is unfavourable. In contrast, project B pays £ 101m regardless of the state of the economy. Assume that the firm is not able to raise any additional funds. Further, assume that investors are risk-neutral, there are no taxes and no direct costs of bankruptcy, the risk-free rate of interest is nil, and the probability of each state of the economy is equal.
i. What is the NPV of each project?
ii. Which project will equity holders want the firm's manager to take? Explain. 
iii. Calculate the magnitude of the agency cost of risk shifting. 
iv . Assume that the firm's manager works on behalf of the equity holders. Should debtholders engage in debt forgiveness and accept a lower debt obligation equal to £ 82m? Explain.
 
 
 
 
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