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Consider an economy with two periods, t=0,1. A firm needs to decide at t=0 whether...

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Finance

Consider an economy with two periods, t=0,1. A firm needs to decide at t=0 whether to invest in A or B. between A and B. The firm expects three possible demands states {H,M,L} at t=1, depending on competition, and the payoff table is below. The three states have equal likelihood of occurring. As investment would cost the firm100, and B could cost 65. Suppose interest rate, r, equals 0, and the firm is risk neutral, i.e., it only maximizes expected returns.

Demand States H M L
A 500 140 50
B 300 200 100

(1) Which option should the firm invest in?

(2) Suppose the firm issues debt with par value 30. Which drug should Pfizer invest in? (Hint: Shareholders decide which drug to invest in, so you should think about their utility).

(3) Suppose the firm issues debt with par value 70. Which drug should the firm invest in?

(4) Determine the equity holders payoff as a function of debt issued, D, for both A and B.

(5) What is the maximum level of debt such that the firm still chooses the option with higher net profit as in (1)?

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