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 Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm’s only activity and that the firm will close one year from today. Fountain is obligated to make a $3,700 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:

4,600

a. What is the expected value of the firm if the low-volatility and high-volatility project is undertaken?

b. What is the expected value of the firm’s equity if the low-volatility and high-volatility project is undertaken?

c. Which project would Fountain’s stockholders prefer?

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 Fountain chooses to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects?

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 Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm’s only activity and that the firm will close one year from today. Fountain is obligated to make a $3,700 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:

Explanation / Answer

a) Expected value of the firm

When Low-volatility project is opted = 0.5 * 3700 + 0.5 * 4000 = 3850

When High-volatility project is opted = 0.5 * 3100 + 0.5 * 4600 = 3850

b) Expected value of Equity

When Low-volatility project is opted = 3850 - 3700 = 1510

When High-volatility project is opted = 3850 - 3700 = 1510

c) Stock holders should prefer, High-volatility project . Because even in the best case the entire debt is paid and equity's value is maximized.

Bond holders must prefer Low-volatility project, since even in the worst case debt can be repaid.

d) Increase the debt outstanding to 3850, so that there is no difference in the projects for the equity holders.

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