Suppose The Entrepreneur Finances The Investment With Outside Equity?

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Question 1

(a) The outstanding face value of this debt stands currently at $60 million The new hire generates 0 NPV. Bruce will not invest it if he is the one to fork out the money.
(b) Since the probability of success will increase only from 1/3 to 1/2 Bruce will not go ahead with this new hire since the NPV of this new hire is negative and Bruce need to finance by himself of 5 million for the new hire.
(c) The new face value of debt that ensures that Bruce pays for the new hire

(d) Shareholders will share the risk of being a flop with Bruce, and at the bad time, shareholders will have a negative loss of 5 million. At the good time, shareholders will ask for the fraction of profits that they require at the beginning of the contract.

Question 2

(a) Suppose the entrepreneur finances the investment with “outside equity”:
According to this case, if the entrepreneur works hard (high effort), investors break even if:

So approximately 44% of stake has to be sold for $70 million. At t = 1, the entrepreneur chooses e =1 (i.e. high effort) if and only if:

Since we finance the investment with equity,

(b) Suppose the entrepreneur finances the investment with debt:

The minimum face value of debt needed to raise $70 millions is 80.
Since we finance with debt,

(c) Given this case, financing the company with debt will generate higher motivation for entrepreneurs to work hard, since 60 is bigger than 46.788.

Question 3

(a)

(b) Project A

Project B

Given the cash flows that debt holders and equity holders can hold under Project A and Project B, manager will choose project B since she makes all investment decisions in the interest of equity holders. Project B

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