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 $4,000 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		$	4,000			$	3,400
Good		.50			4,450				5,050

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?

High-volatility project

Low-volatility project

d. 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, e.g., 32.)

Payment to bondholders           $

Answer 1

a) Statement showing Expected pay off

Economy	Probability	Low Volatility paroject payoff	Expected value	Hogh volatility project payoff	Expected value
Bad	0.5	4000	2000	3400	1700
Good	0.5	4450	2225	5050	2525
Expected value			4225		4225

Expected value of firm would be same under both project =4225$

b) The value of firm's equity is residue value of company after the bond holders are paid off, Thus we need to subtract 4000 from all possible out come and then again calculate expected value

Economy	Probability	Low Volatility paroject payoff	Expected value	Hogh volatility project payoff	Expected value
Bad	0.5	0	0	-600	-300
Good	0.5	450	225	1050	525
Expected value			225		225

Thus Expected value of firms equity will be same under both method i.e 225

C) Low volatility: as it offers same return with less risk

D) Nil since in this case stock holder will not choose high volatility project