Sunburn Sunscreen has a zero coupon bond issue outstanding with a $12,000 face v

Question

Sunburn Sunscreen has a zero coupon bond issue outstanding with a $12,000 face value that matures in one year. The current market value of the firm’s assets is $13,800. The standard deviation of the return on the firm’s assets is 34 percent per year, and the annual risk-free rate is 6 percent per year, compounded continuously. The firm is considering two mutually exclusive investments. Project A has an NPV of $1,500, and Project B has an NPV of $2,300. As the result of taking Project A, the standard deviation of the return on the firm’s assets will increase to 49 percent per year. If Project B is taken, the standard deviation will fall to 21 percent per year.

a-1: What is the value of the firm’s equity and debt if Project A is undertaken?

a-2: What is the value of the firm’s equity and debt if Project B is undertaken?

b: Which project would the stockholders prefer?

c: Suppose the stockholders and bondholders are in fact the same group of investors. Would this affect your answer to (b)?

Explanation / Answer

a-1: What is the value of the firm’s equity and debt if Project A is undertaken?

Ans) Value of the firm is $15,300 in which value of debt is $12,000 and value of equity is $3,300.

a-2: What is the value of the firm’s equity and debt if Project B is undertaken?

Ans) Value of firm is $16,100 in which value of debt is $12,000 and value of equity is $4,100.

b: Which project would the stockholders prefer?

Ans) Stockholders will prefer project B.

c: Suppose the stockholders and bondholders are in fact the same group of investors. Would this affect your answer to (b)?

Ans) Yes, do to this change the firm net assets value of shareholder will change.

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