A struggling company currently has a net worth of $700,000. It owes $500,000 fro

Question

A struggling company currently has a net worth of $700,000. It owes $500,000 from debt financing (assume these are loans from the bank if you wish). The value of the company to the owners is the difference between the net worth and the amount owed to the debt holders. What is the current value of the firm to the owners?

Now assume that a project is presented to the owners that results in a loss of the entire worth of the company with a probability of 50% and results in a gain of $500,000 with probability 50% (resulting in a net worth of $1,200,000). Show that this in expectation decreases the firm

Explanation / Answer

current value of the firm to the owners = net worth - debt = 700000-500000 =$200,000

b) Expected net worth of the company = 50%*0+ 50%*1,200,000 =$600000

This shows that the project decreases the firm

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