Fountain Corporation's economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm's only activity and that the firm will close one year from today. The company is obligated to make a $5,400 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability .50 .50 Bad Good Low-Volatility Project Payoff $5,400 6,550 High-Volatility Project Payoff $ 4,800 7,150 a. What is the expected value of the company if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.) b. What is the expected value of the company's equity if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.) c. Which project would the company's stockholders prefer if they are risk neutral? d. Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total company value and opt for the high-volatility project. To minimize this agency cost, the company's bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if the company chooses to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
Fountain Corporation's economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm's only activity and that the firm will close one year from today. The company is obligated to make a $5,400 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability .50 .50 Bad Good Low-Volatility Project Payoff $5,400 6,550 High-Volatility Project Payoff $ 4,800 7,150 a. What is the expected value of the company if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.) b. What is the expected value of the company's equity if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.) c. Which project would the company's stockholders prefer if they are risk neutral? d. Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total company value and opt for the high-volatility project. To minimize this agency cost, the company's bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if the company chooses to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Fountain Corporation's economists estimate that a good business environment and a
bad business environment are equally likely for the coming year. The managers of the
company must choose between two mutually exclusive projects. Assume that the project
the company chooses will be the firm's only activity and that the firm will close one year
from today. The company is obligated to make a $5,400 payment to bondholders at the
end of the year. The projects have the same systematic risk but different volatilities.
Consider the following information pertaining to the two projects:
Economy Probability
.50
.50
Bad
Good
Low-Volatility
Project Payoff
$ 5,400
6,550
High-Volatility
Project Payoff
$ 4,800
7,150
a. What is the expected value of the company if the low-volatility project is undertaken?
The high-volatility project? (Do not round intermediate calculations and round your
answers to the nearest whole number, e.g., 32.)
b. What is the expected value of the company's equity if the low-volatility project is
undertaken? The high-volatility project? (Do not round intermediate calculations and
round your answers to the nearest whole number, e.g., 32.)
c. Which project would the company's stockholders prefer if they are risk neutral?
d. Suppose bondholders are fully aware that stockholders might choose to maximize
equity value rather than total company value and opt for the high-volatility project. To
minimize this agency cost, the company's bondholders decide to use a bond
covenant to stipulate that the bondholders can demand a higher payment if the
company chooses to take on the high-volatility project. What payment to bondholders
would make stockholders indifferent between the two projects? (Do not round
intermediate calculations and round your answer to the nearest whole number,
e.g., 32.)
Transcribed Image Text:a. Expected company value with low-volatility project
a. Expected company value with high-volatility project
b. Expected equity value with low-volatility project
b. Expected equity value with high-volatility project
c. The company's stockholders prefer if they are risk neutral
d. Payment to stockholders
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