Suppose you are an investor seeking to ?nd new opportunities to invest. You have identi?ed two ?rms: L1 Corporation and BT Enterprises. L1 Corporation is debt free, while BT Enterprises is highly leveraged. Each ?rm is run by an entrepreneur who can exert two levels of e?ort: high or low. The project undertaken by the entrepreneur of each ?rm yields either a high return RS > 0 or a low return RF ? 0, with RF < RS. High e?ort by the entrepreneur increases the probability that the ?rm realizes a high return.
(a) Suppose there are perfect capital markets, no taxes, and no bankruptcy. Suppose also that you (and other outside investors) can perfectly observe the e?ort exerted by the entrepreneurs of the two ?rms, and you can write a contract specifying the e?ort you want the entrepreneurs to exert. Does the amount of leverage of each ?rm a?ect its market value? Explain your answer. (30% of the marks)
(b) Suppose now you and other outside investors cannot observe the e?ort exerted by the entrepreneurs of the two ?rms. In case of a low return, the project undertaken by the entrepreneur of each ?rm yields RF > 0. Does the amount of leverage of each ?rm a?ect its market value? If yes, is there an optimal amount of debt to be issued? Explain.
(40% of the marks)