• Example
• An entrepreneur has two mutually exclusive $50 million investment opportunities, R and S, which it plans to fund with debt
• Project S pays $60 million with certainty
• Project R pays $20 million when the economy is poor and $90 million when the economy is good
• Assume that each state has a ½ (risk-neutral) probability of occurring, and the risk-free rate is 0%
a. What face value must the debt holders be promised?
b. Which project will the entrepreneur select?
c. What does the entrepreneur gain?