1. Nike has a project that will produce cash flows $200 next yearif the economy is strong and $50 if the economy is weak. Supposethe corporate tax rate is 0. The economy will be strong withprobability 50%. Nike issued both debt and equity to raise fundsout of this project as much as possible. Specifically, Nike raised$60 by issuing debt with a face value $80. So, the creditors willreceive $80 in total if the economy is strong but receive only $50if the economy is bad because Nike defaults in this case. Nike alsoraised $50 by issuing equity as much as possible. The market riskpremium is 7% and the risk-free rate is 5%. The entrepreneur ofNike has no equity shares in her firm. Now, suppose there isanother shoes company, New Balance. This firm also has a projectthat will produce $200 next year if the economy is strong and $50if the economy is weak. But the entrepreneur of New Balance wantsto raise only $40 by issuing debt to avoid the chance of default.Assuming issued at risk-free rate and face value of $42 on thedebt. She also plans to issue equity to raise funds as much aspossible out of her project.

1. Suppose investor A is a single investor of Nike, who holds allthe bonds and equities issued by Nike. Also, suppose investor B isa single investor of New Balance. The payoffs to these twoinvestors will be the same?
2. If yes, how much can New Balance raise from equity holders?Does the total amount of funds that can be raised depend on thedefault risk of a firm?
3. What’s the expected return of equity for New Balance? What’sthe equity beta?
4. What’s the cost of capital of New Balance?