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Consider
a firm with $4000 of principal and interest
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payments
due at the end of the year (assume
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$3500
lent at 14.29% stated). If there is
a
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recession,
it will be pulled into bankruptcy
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because
its cash flows will be only $2400.
Else, it
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will
have cash flows of $5000.
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The
firm could avoid bankruptcy in a recession by
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raising
new equity to invest in a new project (soon
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after
beginning). The project costs $1000
and
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brings
in $1700 in either state and has an NPV >
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0.
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Recession
and Boom states are equally likely.
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Will
it do the right thing and raise new equity funds?
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