An entrepreneur has a choice of two mutually exclusive investment projects, Project
A and Project B. Each lasts for one time period and the firm has no other projects.
Project A will result in a cash flow of £27 million in the good state and £10 million in
the bad state. Each outcome is equally likely. Project B will result in a cash flow of
£34 million in the good state and zero in the bad state. Each outcome is equally
likely. Assume the entrepreneur is able to choose which project to undertake after
the finance has been raised.
Each project requires an initial investment of £6 million. Assume risk-neutrality and a
discount rate of zero.

Assume for parts (a) to (c) that the investment is financed by debt.
(a) If Project A is chosen, what is the expected value of the firm and the payoffs
to the debtholders and the entrepreneur?
(b) If Project B is chosen, what is the expected value of the firm and the payoffs
to the debtholders and the entrepreneur? Which is the better project? Which
one will the entrepreneur choose?
(c) Assume the debtholders are fully aware of the firm’s possible investment
choices. They decide to use a bond covenant to stipulate that the face value
of the debt will be £9.2 million if the entrepreneur decides to take on the riskier
project. Which project does the entrepreneur choose now? Is this different
from your answer in part (b)? Why/why not?
(d) Suppose the entrepreneur chooses instead to finance the project with outside
equity. Which project will be chosen? What fraction of the project’s payoff will
the outside equityholders ask for? What is the payoff to the entrepreneur and
the expected value of the firm?
(e) Explain the risk-shifting (asset substitution) agency problem identified by
Jensen and Meckling (1976), with reference to your results in parts (a) to (d).
Is the solution to use as much outside equity as possible? Explain.

Please provide detailed answers, thank you!

Q9

Provided the amplitude is sufficiently great, the human ear can respond to longitudinal waves over a range of frequencies from about 20.0 Hz to about 20.0 kHz. (a) If you were to mark the beginning of each complete wave pattern with a red dot for the long-wavelength sound and a blue dot for the short-wavelength sound, how far apart would the red dots be? m How far apart would the blue dots be? cm (b) In reality would adjacent dots in each set be far enough apart for you to easily measure their separation with a meterstick? Yes No (c) Suppose you repeated part (a) in water, where sound travels at 1480 m/s. How far apart would the red dots be? m How far apart would the blue dots be? cm Could you readily measure their separation with a meterstick? Yes No

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