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