There are two types of firms in the economy, type 1 and type 2. Type 1 firms have assets in place of value $200 and a growth option (investment project) available with NPV of $20. Type 2 firms have assets in place of value $100 and a growth option available with NPV of $5. The up-front investment required to take advantage of the growth option is I=$100 for either firm. The interest rate is r=0. Firms must issue equity to finance the project.

a. Suppose first that there is no asymmetric information, and nobody knows which firm is which. What are the market values of firms 1 and 2. What are the values of firms 1 and 2 after raising capital? What are the old equity holders’ respectively new equity holders’ shares of firms 1 and 2?

b. Suppose now managers know which firm is which and that they act to maximize current shareholders’ value. What will be the old respectively new shareholders’ shares of firms 1 and 2 if both firms choose to issue equity to finance their projects? What is the true value of firm 1 without the investment, with the investment, and with the investment plus the capital raised? What is the true value of firm 2 without the investment, with the investment, and with the investment plus the capital raised? Will firm 1 indeed choose to issue new equity to finance the project? Will firm 2 indeed choose to issue new equity to finance the project? Why?

c. What can the outsiders learn from the issue? What happens to the stock price of firm 2? What will be the old respectively new shareholders’ shares in firm 2?