(Capital Structure IV: Asymmetric information)

Exercise 1
Consider an entrepreneur who has a project that requires an investment of 65 t date 0. At date 2. the project either
succeeds and generates a cash flow of 140 or fails and yields 40. The success probability depends on the effort exerted
by the entrepreneur. At date 1, the entrepreneur chooses the effort level he will exert, e. The effort level is a
continuous variable that takes values in the interval [O, 1). The success probability is the same as the effort level chosen
(p(e ) =1 - e) and the failure probability is 1 - e. Also, the choice of the effort level implies a utility cost for the
entrepreneur given by c ( e) = 𝟓𝟓𝟓𝟓 𝒆𝒆𝟐𝟐 All agents are risk neutral and there is no discounting. The effort level chosen is
not observable
by outside financiers and so it cannot be specified in a contract. Capital markets are perfectly competitive.
a) Suppose that the entrepreneur has enough funds to undertake the project: without borrowing. What effort level will
he choose? Will he invest?

b) Suppose now the entrepreneur has no funds available and raises the

required amount by issuing debt. What is the face value of debt issued? Is

debt riskless? What is the effort level chosen in equilibrium? Will the

entrepreneur undertake the project?

c) Suppose the entrepreneur raises the required amount by issuing equity. What is the effort level chosen in
equilibrium? Will the project be undertaken? Is your answer different from that in Part (b)? Explain briefly why.

Answer 1)
a)
Assuming has invested 65 at period 0.
65 is sunk cost at period 0, does not feature in cost or payoff at period 1.
Expected Revenue (date 1) = (140*p(e) +40*(1-p(e))/ (1+r), p(e)=e, r =0, (since there is no discounting)
=100*e +40

Costs = 𝟓𝟓𝟓𝟓 𝒆𝒆𝟐𝟐

Expected profits = = − 50 𝑒𝑒 2 + 100𝑒𝑒 + 40

maximize Expected profits, 0 ≤ 𝑒𝑒 ≤ 1.

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐: − 100𝑒𝑒 + 100 = 0. → 𝑒𝑒 = 1.

𝑊𝑊ℎ𝑖𝑖𝑖𝑖ℎ 𝑖𝑖𝑖𝑖 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣, 𝑤𝑤𝑤𝑤 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑒𝑒 = 1 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑡𝑡𝑖𝑖𝑖𝑖𝑖𝑖
= −50 + 100 + 40 = 90
The entrepreneur chooses efforts =1, undertakes the project
In case the interval is [0,1), the optimal set is null. Choose any level of effort close to one, there is always another
rational closer to one which is optimal, since 1 cannot be optimal.
The other answers over concave sets are not sensitive to the assumption.
b) For debt, let us assume Gross returns r1, with collateral.
40 + 𝑤𝑤, 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
The borrower gets {
65𝑟𝑟1, ℎ𝑖𝑖𝑖𝑖ℎ
For the entrepreneur
−𝑤𝑤, 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
Profits {
140 − 65𝑟𝑟1, 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔
expected profits = (140 − 65𝑟𝑟1) ∗ 𝑝𝑝(𝑒𝑒) + (−𝑤𝑤) ∗ �1 − 𝑝𝑝(𝑒𝑒)� − 50𝑒𝑒 2
= (140 − 65𝑟𝑟1) ∗ 𝑒𝑒 + (−𝑤𝑤) ∗ (1 − 𝑒𝑒) − 50𝑒𝑒 2 = 𝒆𝒆 (𝟏𝟏𝟏𝟏𝟏𝟏 − 𝟔𝟔𝟔𝟔𝟔𝟔𝟔𝟔 − 𝒘𝒘) − 𝟓𝟓𝟓𝟓 𝒆𝒆𝟐𝟐
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 (Capital Structure IV: Asymmetric information)
Differentiating w r t ‘effort levels’
�100−(65𝑟𝑟1−𝑤𝑤−40)� 𝟔𝟔𝟔𝟔𝟔𝟔𝟔𝟔−(𝒘𝒘+𝟒𝟒𝟒𝟒)
FOC −100𝑒𝑒 + (140 − 65𝑟𝑟1 + 𝑤𝑤) = 0 → 𝒆𝒆 = = 𝟏𝟏 −
100 𝟏𝟏𝟏𝟏𝟏𝟏

SOC : -100 . Profit function is concave weakly non zero at 0 & 1.

Sufficient to say it is non zero at every intermediate value
The project is undertaken, provided W entrepreneur’s wealth > 𝜔𝜔, 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐

The effort exerted reduces by a % difference between the two payoffs.

c) In case of equity, we assume Gross returns = (1+ ror) = ‘r2’. However, there is no ‘w’.

For the entrepreneur

40 (1 − 𝑟𝑟2), 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
Profits {
140 (1 − 𝑟𝑟2), 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔

expected profits = (140(1 − 𝑟𝑟2)) ∗ 𝑝𝑝(𝑒𝑒) + 40(1 − 𝑟𝑟2) ∗ �1 − 𝑝𝑝(𝑒𝑒)� − 50𝑒𝑒 2 = �140(1 − 𝑟𝑟2)�𝑒𝑒 +
40(1 − 𝑟𝑟2)(1 − 𝑒𝑒) − 50 𝑒𝑒 2
We are more concerned with optimal effort level and proceed to take diff wrt e. (Polynomial in e is differentiable to
any finite order in).

100(1−𝑟𝑟2)
First Order Conditions :140(1 − 𝑟𝑟2) − 40(1 − 𝑟𝑟2) − 100𝑒𝑒 = 0 , 𝑒𝑒 = = 1 − 𝑟𝑟2
100

Second Order Condition: -100.

Profit function is concave weakly non zero at 0 & strictly non zero at 1.
Sufficient to say it is strictly positive at every intermediate value. Project is undertaken.

Since cost function is unchanged, changing the reward function will change equilibrium effort.
In case of equity part c, reward function is reduced by same rate in High effort and Low effort case.
In b, any strategy that reduces p(e) raising 1- p(e ) is heavily penalized with coefficient set to negative, irrespective of
which is higher r2 (Risk capital) or Debt r1. Hence in b, we find the reduction in effort is disincentivized by a factor of
(𝒘𝒘 + 𝟒𝟒𝟒𝟒), what he loses in case of losses. Also, debt pays more profits in case of profits since the payouts are
barred at 65r1, instead of full 140 r2 which is payable in case of equity.
Debt could see more efforts by entrepreneurs in reasonable conditions.

Exercise 2
Consider an entrepreneur who, at date 1, can choose between two mutually exclusive projects: Risky, Safe. Both
projects require an investment of 90 at date 0. At date 2, the risky project yields either 245 with probability 0.4 or 20
with probability 0.6 whereas the safe project yields either 200 with probability 0.5 or 40 with probability 0.5. All
agents are risk neutral and there is no discounting. The entrepreneur's choice cannot be observed by outside
financiers. Capital markets are competitive.

a) Suppose that the entrepreneur has enough funds to undertake the project without borrowing. Which project will
he choose?

b) Suppose now the entrepreneur has no funds available and raises the required amount by issuing equity. Which
project will he choose? Explain briefly why.

c) Suppose the entrepreneur raises the required amount by issuing debt. What is the face value of debt issued in
equilibrium? Which project will be chosen? Is your answer different from that in Part (b)? Explain briefly why.

d) Suppose the entrepreneur raises the required amount of funds by issuing convertible debt with face value 140
which can be converted into 70% of the chosen project's equity. Which project will the entrepreneur choose? Is this
an equilibrium? Explain briefly your answer.

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 (Capital Structure IV: Asymmetric information)
Answer 2)

a) The Game: At history of 0, entrepreneur gets to choose between risky and safe. At history 1, profit or loss is chosen
by nature, entrepreneur cannot control/ observe at history 1. At history terminal, 2, entrepreneur gets payoff.
h= 0, investment 90, player entrepreneur

risky safe

h=1, player: Chance/ Nature

profits loss profits loss

h=2, results player:Null

245 20 200 40
payoffs 155 -70 110 -50

We will work by Backward induction, ignoring discounting.

At period 1, actions at h0 get observable.
We are provided probability function support of strategy by nature | risky and safe actions.
Expected payoff of risky project (h = 1) = 155 ∗ .4 − 70 ∗ .6 = 20
Expected payoff of safe project (h = 1) = 110 ∗ .5 − 50 ∗ .5 = 30.
At h0. all actions at h1 and outcomes are unknown, however what is known is Expected payoff | risky
project & Expected payoff | risky project.
Expected payoff of risky project (h = 0) = 20
Expected payoff of safe project (h = 0) = 110 ∗ .5 − 50 ∗ .5 = 30.

Since expected payoff of safe project strictly dominates expected payoff risky project.
The entrepreneur should always choose (p=1) safe project at node h=0.

b) The Game: At history of 0, entrepreneur gets to choose between risky and safe. At history 1, profit or loss is
chosen by nature, entrepreneur cannot control. At history terminal, 2, entrepreneur gets payoff.

h= 0, investment of borrowed equity, player entrepreneur

risky safe
h=1, player: Chance/ Nature

profit losses profit losses

h=2, outcomes, players = ∅

245(1 − 𝑟𝑟1) 0, 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 200 (1 − 𝑟𝑟1) 0 , bankruptcy

The payoff function at h =2 is typical to risk capital. Whatever be the gains, the pay-out is appropriated at a rate of return/
sharing ratio. In case of losses, since 90> 40 & 90 >20, the firm is dissolved (Assume 0 for payout).
We will work by Backward induction, ignoring discounting.
At h1, action taken in h0 is observable by nature who then assigns probabilities to his strategy set: Profit & losses.
We know Chances’ support set of strategy profits and losses, given risky and given safe
Expected payoff | risky at h1 = 245(1 − 𝑟𝑟1) × .4 + 0 ∗ .6

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 (Capital Structure IV: Asymmetric information)
Expected payoff |safe at h1 = 200 (1 − 𝑟𝑟1) × .5 + 0 ∗ .5

Folding back the game to h=0, where player one has to set his strategy, with 0 discounting.

Expected payoff | risky at h0 = 245(1 − 𝑟𝑟1) × .4 + 0 × .6 =(1 − 𝑟𝑟1) × 245

Expected payoff |safe at h0 = 200 (1 − 𝑟𝑟1) × .5 + 0 × .5 = (1 − 𝑟𝑟1) × 200

We see risky project strictly dominates safe project.

c) The Game: At history of 0, entrepreneur gets to choose between risky and safe. At history 1, profit or loss is
chosen by nature, entrepreneur cannot control/ observe at history 1. At history terminal, 2, entrepreneur gets
payoff.

h= 0, investment 0, player entrepreneur

risky safe

h=1, player: Chance/ Nature

profit losses profit losses

h=2, outcomes, players = ∅

245-𝑟𝑟̅ −𝜔𝜔 200-𝑟𝑟̅ −𝜔𝜔

Assume to fixed interest repayment is 𝒓𝒓� > 𝟗𝟗𝟗𝟗 > 𝟒𝟒𝟒𝟒 + 𝝎𝝎. 𝑰𝑰𝑰𝑰 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒐𝒐𝒐𝒐 𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍, 𝒂𝒂𝒂𝒂𝒂𝒂 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 + 𝝎𝝎 𝒊𝒊𝒊𝒊 𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇.
Thus we get our payoffs at h=2. We will use backward induction. We are ruling out the trivial case where lenders are
secure: will always get their amount

At period 1, actions at h0 get observable.

We are provided probability function support of strategy by nature | risky and safe actions by entrepreneur at h=0.
Expected payoff of risky project (h = 1) = (245 − 𝑟𝑟̅ ) ∗ .4 − 𝜔𝜔 ∗ .6 = 98 − .4𝑟𝑟̅ − .6 ∗ 𝜔𝜔

Expected payoff of safe project (h = 1) = (200 − 𝑟𝑟̅ ) ∗ .5 − 𝜔𝜔 ∗ .5 = 100 − .5 ∗ 𝑟𝑟̅ − .5 ∗ 𝜔𝜔

𝒓𝒓� > 𝟒𝟒𝟒𝟒 + 𝝎𝝎. → 𝟒𝟒𝟒𝟒 − 𝒓𝒓� + 𝝎𝝎 < 𝟎𝟎 → 𝟒𝟒−. 𝟏𝟏𝒓𝒓�+ . 𝟏𝟏𝟏𝟏 > 𝟎𝟎 (𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔 𝒃𝒃𝒃𝒃 . 𝟏𝟏)
→ 𝟐𝟐−. 𝟏𝟏𝒓𝒓�+ . 𝟏𝟏𝟏𝟏 > 𝟎𝟎

At h =0, Since there is no discounting

Expected payoff |safe project - Expected payoff of risky project = 𝟐𝟐−. 𝟏𝟏𝒓𝒓�+ . 𝟏𝟏𝟏𝟏 > 𝟎𝟎
Best response of entrepreneur will be to choose safe project as safe project strictly dominates risky projects.

Whenever losses are penalised more, entrepreneurs will try to choose projects with lower chances of failure. In case of
losses when equity is raised loss is less disincentivised, entrepreneur will go by profits, and profits look greener in risky
projects.

d) Convertible shares deal with the issue of unaffordable collateral. Suppose the firms owe more pay-out, when high
risks (high profits) are incurred than the secure Profit prototype.
So in losses, we do not usurp any collateral rather payoff is 0 (Just an assumption: Firm is scrapped).
However higher than normal profits are penalised by higher conversion / debt to be payable.
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 (Capital Structure IV: Asymmetric information)
We try to see if this can be an effective signalling strategy in one player 3 history game, such that it is in best interest
of firms to play safe. In case of safe investment, 140 =200*.7, hence convertibility
keeps it a debt. In case of risky investment however we see 245*.7 = 171.5 >> 140 , hence borrower’s best interest is
to exercise convertibility.

h =0, investment of others’ money. Player: entrepreneur

risky safe

h = 1. Player: Nature

profit loss profit loss

245*.3 0 200-140 0

Payoff 73.5 0 60 0 h=2, terminal node ,player =∅ Outcomes

Since strategy of nature at h1 | risky and safe are known, we can fold the game back to h =1 and 0 recursively.

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝| 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅ℎ=1 = 73.5 ∗ .6 + 0 = 29.4

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝| 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆ℎ=1 = 60 ∗ .5 + 0 = 30

Folding back the tree to h =0,

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝| 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅ℎ=0 = 29.4

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝| 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆ℎ=0 = 30

We see that Playing safe again dominates playing risky, and such an equilibrium Best Response will be to always
choose safe.
Reiterating, excess risks were penalised for the firm by rewarding excess of dues by way of convertibility options in
case of excess profits.

Exercise 3
Consider a firm run by an entrepreneur. At date 0, the entrepreneur has an opportunity to invest in a project. The
investment cost is 100. The returns of the project are realised at date 2 and are either 240 with probability ⅔ or 60
with probability ⅓. At date 0, the entrepreneur has no funds available and raises the required funds by issuing debt.
Capital markets are competitive. Assume universal risk neutrality and no discounting.
a) What is face value of debt issued at date 0?

b) Suppose that at date 1 the entrepreneur discovers an additional investment opportunity which requires an
investment of 12 and increases the probability of the good state (high returns) to ¾. What is the new project's NPV?

c) Suppose that the required funds at date 1 are raised by issuing equity. Will the entrepreneur undertake the new
project? Explain briefly why.

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 (Capital Structure IV: Asymmetric information)
d) Suppose now that required funds at date 1 are raised by issuing debt senior to the debt issued at date 0. Will the
entrepreneur undertake the project? Is your answer different from that in Part (c)? Explain briefly why.

Answer 3)
a) Capital markets are competitive & full information at date 0 → (ⅰ) Collateral =0
2 1
(ⅱ) 𝑵𝑵𝑵𝑵 𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂: 100 ∗ (1 + 𝑟𝑟) × + 60 ×
3 3
= 100 × (1 + 0)2 , 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑑𝑑𝑑𝑑𝑑𝑑𝑐𝑐𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑎𝑎𝑎𝑎𝑎𝑎 0. 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑡𝑡ℎ𝑖𝑖𝑖𝑖 3%
𝑅𝑅𝑅𝑅𝑅𝑅 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑏𝑏𝑏𝑏 100 × 1.032 , 𝑗𝑗𝑗𝑗𝑗𝑗𝑗𝑗 𝑓𝑓𝑓𝑓𝑓𝑓 𝑒𝑒𝑥𝑥𝑥𝑥𝑥𝑥𝑥𝑥𝑥𝑥𝑥𝑥
3 1
→ 𝑟𝑟 = �80 × × � − 1 = 0.2
2 100

Face Value of debt =100 ∗ (1 + .2) = 𝟏𝟏𝟏𝟏𝟏𝟏

120
b) high

don’t invest
h=o, player: firm low 0
Invest 100

h=1 high 120

player: invest
firm 12
h1α
Player: 0
Nature h=2
Player = ∅, Outcomes.

Representation of the discrete period choice problem in a tree form.

At h 1α
Nature observes what player 1 has chosen and conditionally assigns probabilities to
high and low.
We know probability of High| invest = ¾
3 1
Expected Value | choice to invest = × 120 + × 0 = 90
4 4

Folding to h=1,
NPV of existing firm at h1| invest = 90-12 =88 >80 = NPV at h1| don’t invest

c) If the firm incurs losses equity owners get 0, since claim of debt is senior to that of equity
gets min (100,60) i.e. nothing is left for equity
12
Assuming competitive debt, required return on equity r1 = (1 + 𝑅𝑅𝑅𝑅𝑅𝑅) × 12 = 3 = 16.
4
(No arbitrage)
16
RoR = − 1 = 1/3
12

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 (Capital Structure IV: Asymmetric information)
120

high

don’t invest

h=o, player: firm low 0

Invest 100
h=1 high 120 -16
player: invest =104
firm 12
h1α
Player: 0
Nature h=2
Player = ∅, Outcomes.
3 1
Expected Value of existing firm | choice to invest = × 104 + × 0 = 3 × 26 = 78
4 4
2
Expected Value | choice not to invest =120 × = 80
3

Since assured returns (RoR) has to be higher to Stock less senior.

Investors shall need

d) Assume that he issues debt senior to previous debt:

3 1
No arbitrage in Competitive markets: 12 = × 12 × (1 + 𝑟𝑟) + 12 × , 𝑟𝑟 = 0
4 4
high 120

don’t invest 0

h=1
player: invest high 120-12 =108
firm 12

h1α 0
Player: Nature h=2 Player = ∅, Outcomes

3
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 | 𝑐𝑐ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 ℎ1= × 108 = 3 × 27 = 81
4

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 | 𝑐𝑐ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑛𝑛𝑛𝑛𝑛𝑛 𝑡𝑡𝑡𝑡 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 ℎ1 = 80

It is optimal for the entrepreneur to invest borrowing senior debt.

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 (Capital Structure IV: Asymmetric information)
The cost of senior debt is 12, lower than 16, cost of equity.
NPV of current firm/ existing stakeholders increases as a result. While senior debt is lucrative (0 risks for
entrepreneur), riskless equity is too expensive. However, Entrepreneur is seamlessly/ costless putting the owners of
bond in period one at risk.

References / Suggested Readings:

1. William G. Gale 1990, Chapter 2: “Collateral, Rationing, and Government Intervention in Credit Markets”,
National Bureau of Economic Research Project Report, compiled by R Glen Hubbard.

2. Cho, I. and David M Kreps,1987, “Signalling games and stable equilibria”, Quarterly Journal of Economics.
3. Grossman, S.J. and M. Perry,1986, “Perfect sequential equilibrium” Journal of Economic Theory
4. Leland Hayne and David Pyle, 1977,“Informational asymmetries financial structure and financial
intermediation” Journal of Finance.
5. Myers and Stewart C.,1977, “Determination of corporate borrowing Journal of Financial Economics”
6. Myers and Stewart C.,1984, The capital structure puzzle Journal of Finance.

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