4. The Fountain Corp. estimates that the probability of a good business environm

Question

4. The Fountain Corp. estimates that the probability of a good business environment next year is equal to that of a bad business environment. The managers must choose between two mutually exclusive projects. It will be the only project done next year, so the payoff of the project is the value of the firm. The firm has to make a $500 payment to bondholders at the end of the eyar. The two projects are outlined below: Low-risk Project Economy Probability Project Payoff Value of Firm Value of Stock Value of Bonds Good .5 700 700 200 500 Bad .5 500 500 0 500 High-risk Project Good .5 800 800 300 500 Bad .5 100 100 0 100 Which project do shareholders prefer and why?

Explanation / Answer

Low risk Economy Good Bad Average (Prob x Pay off) Prob 0.5 0.5 Pay off 700 500 600 Value of firm 700 500 600 Value of stock 200 0 100 Value of debt 500 500 500 High Risk Economy Good Bad Average (Prob x Pay off) Prob 0.5 0.5 Pay off 800 100 450 Value of firm 800 100 450 Value of stock 300 0 150 Value of debt 500 100 300 The Expected value of equity is higher in high risk project therefore shareholders will prefer high risk project Please provide feedback…. Thanks in advance…. :-)

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