Question

Your firm consists of $1,000 in cash. You have two potential investment opportunities, both cost $1,000 today. Project 1 pays $2,200 at the end of the year with 50% probability and $0 with 50% probability. Project 2 pays $10,000 at the end of the year with 10% probability and $0 with 90% probability. Assume the discount rate is 0%.

Assume that you also have a debt contract whereby you owe $X to a debtholder at the end of the year. The contract specifies that you cannot pay dividends until after he is repaid. You have no other liabilities.

What is largest debt payment for which you would prefer to the first project?

Answer 1

Your firm consists of $1,000 in cash

As it is said, First Project would be prefer for Largest Debt Payment and as per the Debt contract end of the year the compnay have to pay and it also have other Liabilities.

Investment = $1000

Project A -

Pay = $2200 with 50% Proability

Pay= $0 with 50 % Proability

So= 2200*0.5 + 0 *0.5

= $1100

Project B-

Pay = $10000 with 10% Proability

Pay= $0 with 90 % Proability

So= 10000*0.1 + 0 *0.9

= $1000

So, Debt payment can be $1100