Fountain Corporation\'s economists estimate that a good business environment and

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 $5,000 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 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.) Expected value of the company Low yolatlity projedt High-volallity project 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.) Expected value of the company's equity Low-volatity project High-volablity project e. Which project would the company's stockholders prefer? 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.)

Explanation / Answer

1) Low-volatility project value = 0.50($5,000) + 0.50($5,950) $5,475 High-volatility project value = 0.50(4,400) + 0.50($6,550) $5,475 Both the low-volatility project and High - volatility project have the same expected value of the firm so both are are equal 2) Expected value of equity with low-volatility project = 0.50($5000 - 5000) + 0.50($5950-5000) $475 Expected value of equity with high-volatility project = 0.50(4400 - 5000) + 0.50($6,550-5000) $775.00 3) The company stockholders will prefer the high volatility project since it maximizes the expected value of the company’s equity. 4) Let X be the debt payment that bondholders will require if the high-volatility project is undertaken. In order for stockholders to be indifferent between the two projects, the expected value of equity if the high-volatility project is undertaken must be equal to $475 Expected value of equity = $475 = 0.50($0) + 0.50($6,550 – X) Payment to bond holder = X = ((.50 *$6550)-$475).50 $5,600

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