Consider a firm that currently has debt with face value of $1000 that will come due in one year and assets that are projected to be worth $900 in one year.
Suppose the firm has the opportunity to invest in a new project requiring an immediate investment of $100 and offering a return of 50% in one year.
Suppose the only way to get the $100 for the initial investment is for the existing equity holders to contribute it.
Assume the required rate of return for this project is less than 50%, should the firm invest in the project?
Compare the value of the firm, the debt and equity (i) without a change to strategy and (ii) with a change to strategy (assume 0% discount rate). Will the manager invest in the project if her goal is to maximize shareholders’ value?