Question

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 $3,800 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 Low-volatility Project High-volatility Project Payoff Payoff Bad .50 $3,800 $3,200 Good .50 $4,000 $4,600 (a) What is the expected value of the company if the low-volatility project is undertaken? What if the high-volatility project is undertaken? Which of the two strategies maximizes the expected value of the firm? (b) What is the expected value of the company's equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken? (c) Which project would the company's stockholders prefer? Explain. (d) Suppose bondholders are fully aware that stockholders might choose to maximize equity value and opt for the high-volatility project. How would bondholders protect themselves at the time when bondholders lend to the firm.

Answer 1

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C w ENG 06:31 30-07-2020 99+ 30 Х GU401 . GM GN GO GP GQ GU GV GW GX 396 PROB 397 398 399 400 401 ECONOMY BAD GOOD GR GS GT LOW VOLATILITY HIGH VOLATILITY PAYOFF PAYOFF 3800 3200 4000 4600 0.5 0.5 A 402 EXPECTED VALUE OF FIRM LOW VOLATILITY HIGH VOLATILITY SAME VALUE UNDER BOTH THE CASES 3900 0.5*3800 + 0.5*4000 3900 0.5*3200 + 0.5*4600 B 403 404 405 406 407 408 AS DEBT HOLDERS MUST BE PAID FIRST, THE EXPECTED VALUE OF EQUITY LOW VOLATILITY 100 [= 0.5*(3800-3800) + 0.5*(4000-3800)] HIGH VOLATILITY 400 [= 0.5*(3200-3200) + 0.5*(4600-3800)] (IF PAYOFF IS LESS THAN 3800, 3200 WILL BE PAID TO DEBT-HOLDERS) с HIGH VOLATILITY PROJECT AS VALUE OF EQUITY IS HIGHER D 409 410 411 412 413 414 415 416 417 418 419 + TO MAKE STOCKHOLDERS INDIFFERENT BETWEEN 2 PROJECTS BONDHOLDERS HAVE TO INCREASE THEIR DEBT LEVEL THE EXPECTED VALUE OF EQUITY IS 100 UNDER LOW VOLATILITY PROJECT SO 100 = 0.5(0) + 0.5(4600-X) 100 = 2300 - 0.5 X X = 4400 AMOUNT OF BONDHOLDERS SHOULD BE $4400 EAC MACRS RELEVANT MI-np-ir BETA LEVERED NPV CCA REPLACEMENT BOND OPTION TO WAIT STEIN indiffEPS EBIT OCF 1 LEA ... +