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Caratinga is a 100% equity company whose only option is to invest either in project A or project B (i.e., it can only invest in A or only invest in B). Each project requires an investment today of €500 million. Next year, project A pays €650 million with probability 75% and €250 million with probability 25%. Next year, project B pays €800 million with probability 25% and €250 million with probability 75%. After these cash flows, the firm will be shut down. There are no taxes, depreciation, or any other benefits. In order to implement one of these projects, the company must raise debt financing. The managers of the company act in the best interest of equityholders. Debtholders can rationally anticipate the actions of managers. Assume all cash flows are discounted at 0%.
a) Compute the NPVs of the two projects. Which project is better? If there were no financial constraints, in which project(s) would you invest?
b) Show that the company will be able to raise €500 million today via the issue of debt if it guarantees contractually that project A is chosen. Compute the terms of the debt (i.e., the face value), required by the lenders. Be precise: show your steps and explain your reasoning.
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