ECO3592011 UniversityofToronto PracticeProblems5HSolution DepartmentofEconomics ECO 359 Practice Problems 5 Suggested Solution 1. (DEBT OVERHANG ) (a) Air Ontarios expected value is ,IHH 0 HJ - H 0 Hz L ,JH If Mrs. Lulu gets involved and invests, Air Ontarios expected value becomes ,IHH 0 :HJ - ; - H 0 :Hz . ; L ,JH - ,IHH 0 . The NPV of the project for Mrs. Lulu is & L .,JH - ,JH - ,IHH 0 . ,JH , ; ? since her initial investment is F = 20 million dollars, and she gets all the extra profit the company makes >:,JH - ,IHH 0 . ,JH . ? Mr. Lulu will invest if and only if & 4 H, i.e., & L .,JH - ,IHH 0 4 H 4 HJ (b) No. The trick is in the word extra if the union insists that workers have a legal claim of face value B = $40M before Mr. Lulu, the extra profits for Mrs. Lulus investment is :HJ - HK ,IHH . ,LH . HJ ,IHH . ,LH L ,Iz; The cost of the project is $20M, which is above the $18M expected profits. (c) Mr. Lulu is willing to invest if and only if is the NPV of the project is non-negative.