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Investors know that firm XYZ can be of two types: either good (G) or bad (B). If XYZ is good, its assets will generate a cash-flow of $40 million starting next year and continuing forever. If XYZ is bad, its assets will generate a cash-flow flow of $20 million starting next year and continuing forever. Today, firm XYZ, regardless of its type, has an investment opportunity: a new project that requires $50 million today and generates a cash-flow of $66 million next year only. Assume all risk is diversifiable and the risk-free rate is 10%. Firm XYZ is currently an all-equity firm.

1. What is the NPV of the investment opportunity? [3 marks]

2. In perfect capital markets, will XYZ finance this opportunity? [3 marks]

3. Assume XYZ is of a good type and all investors know it. Assume existing shareholders do not have sufficient funds to undertake the project and decide to finance it by issuing new equity. What fraction of equity should the firm sell to raise sufficient funds? Is it in existing shareholders interest to do so?

   [7 marks]

4. Assume that, irrespective of its type, XYZ issues equity and that, accordingly, outside investors believe that the equity is issued by a good type firm with 50% probability. What fraction of equity does XYZ have to sell to raise sufficient funds? Now, assume that XYZ is actually of the good type. Is it in XYZs existingshareholders interest to issue equity under these conditions?

5. What would be your advice to this firm?

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