Consider a market in which half of all firms are weak firms and the other half are strong. There is no way for an investor to distinguish between firms that are strong and firms that are weak. At the end of the present year, all firms will be liquidated.
Each firm currently has an investment opportunity. Assume that no firm has cash on hand to finance the investment.
The interest rate is zero. The structure of each firm is specified in the table below:
|
Firm Type
|
Liquidation Values Next Year without the Project
|
Liquidation Values Next Year with the Project
|
Cost of the Project
|
|
Strong
|
$150
|
$260
|
$90
|
|
Weak
|
$50
|
$150
|
$90
|
A. If each firm finances the project by selling bonds, determine for each firm the increase in its shareholders' wealth, and the total market value of the firm's shares.
B. If each firm could finance the project by issuing additional shares, which type of firm would undertake the project?
C. How could an investor use a firm's financing strategy to determine if that firm is strong or weak?