You are the CEO of a just formed company that will last exactly 1 year and then

Question

You are the CEO of a just formed company that will last exactly 1 year and then be liquidated. The initial capitalization of the company consists of:

Debt:          $10,000

Equity:         $ 4,000

You have the choice of only 2 investment alternatives with the initial capital. Each project will require the investment of the entire initial capital.

Project 1 has a 60% chance of paying $9,000 and a 40% chance of paying $7,000.

Project 2 has a 10% chance of paying $50,000 and a 90% chance of paying $3,000.

Issuers of Debt and Equity are assumed risk neutral.

Which project do bondholders want you, the CEO, to choose? Explain and provide supporting computations where appropriate.

Which project do shareholders want you, the CEO, to choose? Explain and provide supporting computations where appropriate.

Explanation / Answer

Solution: Project A Cash inflow cash flow 60%                      9,000                  5,400 40%                      7,000                  2,800 Total cash inflow                  8,200 Project B Cash inflow cash flow 10%                   50,000                  5,000 90%                      3,000                  2,700 Total cash inflow                  7,700 Note: 1. As issuers of Debt and Equity are assumed risk neutral so project 2 has high probability 2 of not getting the profits back as the Project 2 has a 10% chance of paying $50,000 and a 90% chance of paying $3,000. 2. As bond holder will prefer fixed return than varible so they will prefer Project A because it is giving high return than B 3. As stockholder investing in hope of high return so they will prefer Project B . though probablity is less for 50000 yet they will prefer it as still positive returns. Please let me know if it is incorrect.

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