Consider a biotechnology startup firm. The managers of the firm must choose one

Question

Consider a biotechnology startup firm. The managers of the firm must choose one ofthree different research strategies. The payoffs and their likelihood of success foreach strategy are given in a table below
Strategy  Probability  Payoff ($ millions)

A 100% 75
B 50% 140

50% 0

C 10% 300

90% 40

a) Which of the projects has the highest expected payoff?

b) Suppose that the startup is carrying $40 million in debt that must be paidoff in the next period. Which strategy has the highest expected payoff for

equityholders?

c) Suppose that the startup is carrying $110 million in debt that must bepaid off in the next period. Which strategy has the highest expected

payoff for equityholders?

d) If managers are operating the firm in the interest of the equityholders, aremanagers undertaking a firm value maximizing strategy in b) and c).e) Is this an example of asymmetric information? If so, is it an example of

hidden action or hidden information? Why?

Having trouble with this. Could you please help and show your work? Thank you very much!

Explanation / Answer

a> A has the highest expected pay-off.

b>A will again be the option as the income is assured at 100% and the debt of $40m can be repaid.

c>B will be the option as the debt to be repaid is $110m and this option has a possible income of $1140m.

d> In the absence of complete information , Managers have to make judgement based on past experience and also a kind of intellligent guess work. In both b&c , the options are in the best interest of the equity holders.

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