Question

Sunburn Sunscreen has a zero coupon bond issue outstanding with a face value of $25,000 that matures in one year. The current market value of the firm’s assets is $27,200. The standard deviation of the return on the firm’s assets is 34 percent per year, and the annual risk-free rate is 4 percent per year, compounded continuously. The firm is considering two mutually exclusive investments. Project A has an NPV of $2,300, and Project B has an NPV of $3,100. As the result of taking Project A, the standard deviation of the return on the firm’s assets will increase to 48 percent per year. If Project B is taken, the standard deviation will fall to 29 percent per year.

a-1. What is the value of the firm’s equity and debt if Project A is undertaken? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) Market value Equity $ Debt $

a-2. What is the value of the firm’s equity and debt if Project B is undertaken? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) Market value Equity $ Debt $

b. Which project would the stockholders prefer? Project B Project A

c. Suppose the stockholders and bondholders are in fact the same group of investors. Would this affect your answer to (b)? Yes No

Answer 1