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JJT Inc. is initially an all-equity firm with a market cap of $10bn. The firm now has a new opportunity for a project. For an upfront investment cost of $1,200mn, the project will pay a cash flow of either $2,000mn or $800mn. The payoff would occur in either one or two years with equal probability. The probability that the payoff value would be $2,000mn is:
- 75% if the project is a “good” type,
- 25% if the project is a “bad” type.
In order to invest in the project, the firm requires raising the investment cost through debt or equity financing from new potential investors. The firm and potential investors are risk-neutral, they initially believe there is an equal probability of the project being either the good or bad type, and the risk-free interest rate is zero. Before the firm decides about investing and financing, the firm will learn what the project type is through due diligence.
- a) Suppose that after the due diligence, the project type will be the firm’s private asymmetric information. What is the value to the firm of each project type?
- b) Instead of part (a), suppose that after the due diligence, the project type will be symmetric information, because the project type will also be learned by potential investors. What is the expected value to the firm of the project opportunity before learning the project type?
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