Question

0.5 points 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 company's only activity and that the company will close one year from today. The company is obligated to make a $4.400 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: Low-Volatility High-Volatility Economy Probability Prolect Payoff Project Payoff Bad 50 $4,400 $3,800 Good 50 5.050 5.650 Print References a. What is the expected value of the company of 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 of 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.... 32) a. Expected company value with low-volatility project Expected company value with high-volatility project Expected equity value with low-volatility project Expected equity value with high-volatility project The company's stockholders prefer if they are risk neutral? d. Payment to stockholders

Answer 1

a) Expected value of the firm $ 4,725 4400*0.5+5050*0.5 Low-volatility project value 4,725 3800*0.5+5650*0.5 High-volatility project value b) Expected value of the firm's equity 3250*0.5+(5050-4400) * 0. 5 Low-volatility project value $ 625 0*0.5+(5650-4400)*0. 5 High-volatility project value e) Fountain's stockholders prefer "High-volatility project" $ 5,0005650-325/0.5 d) Payment to bondholders

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