Question

Suppose there are two potential projects for investment. Project 1 has a certain payoff of $50 in one year, while project 2 has a 50% chance of generating $100 in one year, and another 50% chance of generating $0 in one year. Suppose the company has an outstanding debt = $50.

(1)Which project will shareholders prefer? Justify your answer.
(2)Which project will debt holders prefer? Justify your answer.
(3)Which project will the financial manager prefer? Justify your answer.

Answer 1

As Project 1 has certain payoff of $ 50, and Project 2 has 50% chance each of generating $ 100 and $ 0 respectively with expected return of $ 50, there is a difference between the two payoffs.

1)

From a shareholders perspective, choosing project 1 does not yield any returns as the certain $ 50 will be used to payoff the debts. However in Project 2,there is a chance of generating $ 100, of which $ 50 can be used to repay the debts, so the shareholders will have a return of $ 50. Thus shareholders would prefer Project 2.

2)

From a debt holders perspective, choosing the certain $ 50 is always preferred compared to probable payouts. So Project 1 will be preferred.

3)

From a financial manager perspective, his/her major fiduciary duty is to work in the best interest of the shareholders for the long term. Though choosing project 2 may seem to be in the best interest, there is a chance of the firm going bankrupt and closing down. To prevent such an occurance, financial manager would choose Project 1 for the long term benefit of the organization and shareholders,  though shareholders do not get anything in return in the immediate year.

Answer 2

Project 1:

Expected Payoff = $ 50 * 100%

= $ 50

Project 2:

Year	Prob	Payoff	Expected Payoff
1	0.5	$     100.00	$        50.00
2	0.5	$              -	$              -
Expected Payoff	50

Generally Debt holders will receive Int on debt only. Any additional values will not flow to debt holders.

Part1:

Equity holders are ready to take risk and hence they will select Project 2 which is having expedted Payoff of $ 50. However It can gp upto $ 100.

Part 2:

Generally Debt holders will receive Int on debt only. Any additional values will not flow to debt holders.Hence they will choose Project1.

Part 3:

Project 1 is haing expected Payoff of $50 with 0% risk

Project 2 Having expected Payoff of $ 50 with risk.

Hence I will select Project 1.

Pls do rate, if the answer is correct and comment, if any further assistance is required

Answer 3

1. Shareholders will be preferring project 2 because it is offering them with maximisation of their value as it has the probability of earning higher income on they will be selecting project 2 as they will always want to maximize their overall rate of return by taking measured Risk so in this case they will be selecting project 2 instead of project 1 because project 1 is having lower income projection

2.Debtholders will be preferring project 1 because debt holders will always be wanting to protect their capital and not take any unnecessary risk so they will always be wanting to take project 1 and protect themselves from any uncertainty and unnecessary risk as project 2 will be having higher fluctuations and higher risk as it has probability of making higher return.

3. Managers will be wanting to select project 2 because project 2 has capability of earning higher income and managers will always be wanting to maximize the value of the organisation so that shareholders value will be maximized and the job of these managers will be protected.

Answer 4

(1)Which project will shareholders prefer? Justify your answer.

Project 2

Explanation

Shareholders will prefer project 2 because, if we select project 1 it will generate only generate income of $50 which we need to pay towards the debt. But if select project 2 there is chance that we may get $100 in that case after paying the debt $50 will be available for the shareholders.

(2)Which project will debt holders prefer? Justify your answer.

Project 1

Explanation

Debt holders will prefer project 1 because it will generate certain cash inflow of $50, which is sufficient to get his money back. For project 2 there is 50% chance that inflow may be $0 so for debt holder project 1 is beneficial.

(3)Which project will the financial manager prefer? Justify your answer.

Project 2

Explanation

Managers are supposed to take risk and generate more return for the business, if he select project1 business will be able to generate only certain cash inflow of $ 50 but if he take risk then there is a chance that business may get $100. So manager should select project2

Answer 5

As Project 1 has certain payoff of $ 50, and Project 2 has 50% chance each of generating $ 100 and $ 0 respectively with expected return of $ 50, there is a difference between the two payoffs.

1)

From a shareholders perspective, choosing project 1 does not yield any returns as the certain $ 50 will be used to payoff the debts. However in Project 2,there is a chance of generating $ 100, of which $ 50 can be used to repay the debts, so the shareholders will have a return of $ 50. Thus shareholders would prefer Project 2.

2)

From a debt holders perspective, choosing the certain $ 50 is always preferred compared to probable payouts. So Project 1 will be preferred.

3)

From a financial manager perspective, his/her major fiduciary duty is to work in the best interest of the shareholders for the long term. Though choosing project 2 may seem to be in the best interest, there is a chance of the firm going bankrupt and closing down. To prevent such an occurance, financial manager would choose Project 1 for the long term benefit of the organization and shareholders,  though shareholders do not get anything in return in the immediate year.