Question

Question 33 5 pts 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 firm's only activity and that the firm will close one year from today. The company is obligated to make a $3,800 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 High-volatility Project Payoff Payoff Bad 50 $3,800 $3,200 Good .50 $4,000 $4,600 (a) What is the expected value of the company if the low-volatility project is undertaken? What if the high-volatility project is undertaken? Which of the two strategies maximizes the expected value of the firm? (b) What is the expected value of the company's equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken? (c) Which project would the company's stockholders prefer? Explain. (d) Suppose bondholders are fully aware that stockholders might choose to maximize equity value and opt for the high-volatility project. How would bondholders protect themselves at the time when bondholders lend to the firm. HTML For

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06:46 w ENG 99+ 30-07-2020 30 Х N1 . L M N O P Q R S T U 1 2 3 4 5 6 HIGH VOLATILITY PAYOFF ECONOMY LOW VOLATILITY PAYOFF 3800 PROB BAD 0.5 3200 7 GOOD 0.5 4000 4600 8 9 (a) EXPECTED VALUE OF FIRM 10 11 LOW VOLATILITY HIGH VOLATILITY 3900 [ 0.5*3800+ 0.5*4000] 3900 [ 0.5*3200 + 0.5*4600] 12 13 14 BOTH CASES GIVE SAME VALUE EXPECTED VALUE IS SAME 15 16 (b) THE DEBT HOLDERS VALUE = 3800 DETBHOLDERS WILL BE PAID 3800 FIRST AND IF ANYTHING IS LEFT THEN IT IS AVAILABLE TO EQUITY HOLDERS 17 18 19 20 EXPECTED VALUE OF COMPANY'S EQUITY LOW VOLATILITY HIGH VOLATILITY 100 [ 0.5*(3800-3800) + 0.5*(40 300)] 400 [ 0.5*(3200-3200) + 0.5*(4600-3800)] 21 22 23 24 (c) AS VALUE OF EQUITY IS HIGHER IN CASE OF HIGH VOLATILITY PROJECT ASSET L UTILITY LOAN EAIR OLIVER NOMINAL SBUX excel pv fv DAUTEN reinvest Sheet6 Sheet11 CASH FLOW royal

06:46 w ENG 99+ 30-07-2020 30 Х N45 . L M N O Р 0 R S T U 22 23 24 (c) AS VALUE OF EQUITY IS HIGHER IN CASE OF HIGH VOLATILITY PROJECT SHAREHOLDERS WILL GO WITH "HIGH VOLATILITY PROJECT" 25 26 27 28 (d) BONDHOLDERS HAVE TO INCREASE THEIR DEBT LEVEL TO MAKE STOCKHOLDERS INDIFFERENT BETWEEN 2 PROJECTS 29 THE EXPECTED VALUE OF EQUITY IS 100 UNDER LOW VOLATILITY PROJECT 30 31 32 33 34 SO 100 = 0.5(0) + 0.5(4600-X) 100 = 2300 - 0.5 X X = 4400 35 36 AMOUNT OF BONDHOLDERS SHOULD BE $4400 37 38 39 40 41 42 43 44 45 ASSET L UTILITY LOAN EAIR OLIVER NOMINAL SBUX excel pv fv DAUTEN reinvest Sheet6 Sheet11 CASH FLOW royal