Question: It is December of 2011 and Russian Roulette & CO (NYSE: RR&C) has $1,000 in bonds outstanding that needs to be paid off in 2012. RR&C has been struggling since the financial crisis and it expects cash flows to be $900 if the recession persists and 1,500 if the economy recovers in 2012. Economists predict that the probability of a recovery in 2012 is 0.5. The Federal Reserve is keeping interest rates very low so the discount rate can be considered to be zero. RR&C’s CEO will face either one of two investment opportunities described in parts A and B below.

1. RR&C’s CEO has the opportunity to invest $0 in a project that yields -$900 if the dollar depreciates in 2012 and 500 if it appreciates. Exchange rate analysts believe the dollar will appreciate if the economy recovers in 2012 and depreciates if otherwise. Compute the payoffs to debt and equity if RR&C carries out this investment for the scenarios of boom and bust in 2012. What are the expected values of debt and equity under the "no-investment" and "investment" policies? If RR&C’s CEO maximizes only the interest of equity holders, will this investment be made? Will the resulting decision increase or decrease the total value of RR&C?
   
2. RR&C’s CEO just comes across a "negative beta" investment opportunity that results in a payoff of $100 if the economy does not recover and $0 if the economy recovers. The project has an implementation cost of $10. Given the expected NPV of $40 (= $50 - $10), this project is profitable. RR&C faces a tough debt market so this investment must be equity financed. Compute the payoffs to debt and equity if RR&C carries out this investment for the scenarios of boom and bust in 2012. What are the expected values of debt and equity under the "no-investment" and "investment" policies? If RR&C’s CEO maximizes only the interest of equity holders, will this investment be made? Will the resulting decision increase or decrease the total value of RR&C?
   
3. Discuss the concept of "agency cost of debt" based on the choices made by the firm above. What is it? Can it be quantified? How can one address it in a contract?

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