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A company can invest in one of two mutually exclusive projects. The first one is safe and its assets will have a value of EUR 1,000,000 in one year. The other project is risky and its assets, in one year, will have a value of EUR 1,800,000 or EUR 100,000 with equal probability. The initial investment for either projects is 500,000. The company plans to raise the EUR 500,000 by issuing a zero-coupon bond (the project is financed 100% with debt) that will be paid back in one year. The firm cannot commit ex-ante to choose a project. All agents are risk neutral and the interest rate is 0.

A) What is the face value of debt?

B) What is the increase in the equity value after the issuance of the bond is announced?


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