The managers of a firm are asked to consider two possible new product lines for

Question

The managers of a firm are asked to consider two possible new product lines for the firm . Project 1 is quite risky and may result in a market value for the firm of $50 million in two Years ,or nothing .Project 2 is much more certain in outcome and may result in a firm market value as high as $25 million or as low as $15 million.

The face value of the company s debt ,payable in two years is $20 million

a-      What are the possible payoffs to the bondholders under projects 1 and 2

b-      What are the possible payoffs to the shareholders under project s 1&2

c-       Which will the shareholders favor? The bondholders?

Explanation / Answer

a) payoff for the bondholder from project 1 and 2 is 20 million

b) payoff from project 1 is 0.5 * 50 + 0.5 * 0 = 25

payoff from project 1 is 0.5 * 25 + 0.5 * 15 = 20

c) sharholder will prefer project 1 and bondholder can choose between any of the given two projects because are paying the same payoff

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