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 $5,400 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:

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

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

Economy Probability Low Volatility Project Payoff High Volatility Project Payoff Bad .5 $ 5,400 $ 4,800 Good .5 $ 6,550 $ 7,150

Explanation / Answer

Since the projects are mutually exclusive, only one of them can be chosen at a time.

Low volatility project payoff = 0.5 * 5400 + 0.5 * 6550 = 5975
High volatility project payoff = 0.5 * 4800 + 0.5 * 7150 = 5975

Since the payoff is same, firm can choose any project.

Expected value of firm = $5,975

Debt payment at the end of the year = 5400

So value of equity = 5975 - 5400 = $575

Related Questions

Navigate

• Browse (All)
• Browse F
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.