Problem
Debt contracts represent fixed claims against the firm, while an equity contract entitles the shareholder to claim against the residual cash flows of the firm. Consider a small firm with one shareholder, the entrepreneur who started and runs the firm. The firm's debt consists of loans from the local commercial bank. The firm's primary source of revenues is exports to Singapore. Because of the Asian financial crisis, the firm is facing considerable reduction in cash flows. The manager has two investment projects. One is a safe project that will only generate sufficient cash flows to cover the firm's debt obligations. The other project is considerably riskier, but if successful will generate twice the firm's normal annual revenue. Which project do you expect the entrepreneur to undertake? Explain.