Consider a firm with assets in place that generate 200 in state H with probability 50%, 100 in state M with probability 25%, and 0 in state L with probability 25%. The firm also has cash on its balance sheet in the amount of 100. The assets of the firm are financed with equity and zero-coupon debt with face value 200.

(a) Construct the balance sheet.

(b) The manager discovers a project that costs 50 and generates 80 in state H with probability 50%, 80 in state M probability 25%, and 0 in state L with probability 25%. What is the project’s NPV?

(c) Suppose that the firm finances the project internally by using half of its cash reserve. Construct the resulting balance sheet. Do shareholders accept or reject the project?

(d) Suppose that restrictive debt covenants do not allow the firm to use its cash reserve for financing the project. Instead, the firm considers taking a new loan, which is junior to existing debt. Construct the balance sheet with the project and junior debt financing. Do shareholders accept or reject the project?

(e) What does this numerical example tell you with respect to the separation theorem of Modigliani and Miller?