Choosing Strategies
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A firm has debt maturing two years from now with face value $100 million. The firm can choose one of two strategies, the first offering a 60% chance of total payoff $120 million and a 40% chance of $105 million, either to come in two years. The second strategy offers a payoff in two years that is $160 million with 70% probability and $50 million with 30% probability. Neither of these strategies involves market risk, and the firm will have no going-concern value beyond year 2. Equity holders would choose Strategy __________, while if managers acted in the interest of the firm as a whole, they would select __________.
a. 1, Strategy 1
b. 1, Strategy 2
c. 2, Strategy 1
d. 2, Strategy 2
e. 2, either strategy
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The solution tells you the correct answer and explains how it was found and why it is correct.
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The theoretical answer to the question is: The Equity holders will choose the one with the most return and ...
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