Question

Sheaves Corporation economists estimate that a good business environment and a bad business environment are equally likely for the coming year. Management must choose between two mutually exclusive projects. Assume that the project chosen will be the firm’s only activity and that the firm will close one year from today. The firm is obligated to make a $4,500 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:

Economy		Probability		Low-Volatility Project Payoff				High-Volatility Project Payoff
Bad		.50		$	4,500			$	3,900
Good		.50			5,200				5,800

a. 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, e.g., 32.)

Expected value of the firm
Low-volatility project value	$
High-volatility project value	$

b. 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, e.g., 32.)

Expected value of the firm's equity
Low-volatility project value	$
High-volatility project value	$

c. Which project would the firm’s stockholders prefer?

Low-volatility project

High-volatility project

Answer 1