Question

Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the company’s only activity and that the company will close one year from today. The company is obligated to make a $5,300 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	$ 5,300	$ 4,700
Good	.50	6,400	7,000

  

a.	What is the expected value of the company if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.)
b.	What is the expected value of the company’s equity if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.)
c.	Which project would the company’s stockholders prefer if they are risk neutral?
d.	Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total company value and opt for the high-volatility project. To minimize this agency cost, the company's bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if the company 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 answer to the nearest whole number, e.g., 32.)

Answer 1

A. Value of Company :

Low-Volatility Project Payoff = $5850

High-Volatility Project Payoff = $5850

B.value of equity

Low-Volatility Project Payoff = $550

High-Volatility Project Payoff = $850

c. Which project would the company’s stockholders prefer if they are risk neutral?

if investor are risk neutral they invest in project which gives high return Thus, High Volatility Project

D. Indifferent Payment

0*0.5+(7000-x)*0.5=550

7000-x = 1100

X = $5900

Payment to bondholders would make stockholders indifferent between the two projects = $5900