Sheaves Corporation economists estimate that a good business environment and a b
ID: 2785270 • Letter: S
Question
Sheaves Corporation economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Sheaves must choose between two mutually exclusive projects. Assume that the project Sheaves chooses will be the firm’s only activity and that the firm will close one year from today. Sheaves is obligated to make a $4,800 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:
What is the expected value of the firm if the low-volatility project is undertaken? What if the high-volatility project is undertaken? (Do not round intermediate calculations and round your answers to the nearest whole dollar amount (e.g., 32).)
What is the expected value of the firm’s equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken? (Do not round intermediate calculations and round your answers to the nearest whole dollar amount (e.g., 32).)
Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total firm value and opt for the high-volatility project. To minimize this agency cost, the firm's bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if the firm 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 answers to the nearest whole dollar amount (e.g., 32).)
Sheaves Corporation economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Sheaves must choose between two mutually exclusive projects. Assume that the project Sheaves chooses will be the firm’s only activity and that the firm will close one year from today. Sheaves is obligated to make a $4,800 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:
Explanation / Answer
a) Expected Payoff is the sum of Probability of the Economy multiplied by the payoff
$5,225.00
b) The value of the equity is the residual value of the company after the bondholders are paid off. If the low-volatility project is undertaken, the company's equity will be worth $0 if the economy is bad and $750 if the economy is good.
c) Stockholder's would prefer high volatility projected as the expected equity value is higher.
d) In order to make stockholders indifferent between the low-volatility project and the high-volatility project, the bondholders will need to raise their required debt payment so that the expected value of equity if the high-volatility project is undertaken is equal to the expected value of equity if the low-volatility project is undertaken.
425 = (1450 - X)*0.5
850 = 1450 - X
X = 600
$5,225.00
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