Fountain Corporation’s economists estimate that a good business environment and
ID: 2744594 • Letter: F
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 $3,600 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? (Do not round intermediate calculations. Enter your answers in whole dollars.)
What is the expected value of the firm’s equity if the low-volatility and high-volatility project is undertaken? (Do not round intermediate calculations. Enter your answers in whole dollars.)
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? (Do not round intermediate calculations. Enter your answer in whole dollars.)
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 $3,600 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
Value of equity = Value of firm - Value of debt
a) Expected value of the firm =
b) Expected value of the firm's equity
125
c) Further increase their value as a priority consideration , the shareholders should choose to invest in high-risk cases .
d) When selected high-risk investments to make the case , the amount paid creditors from $ 500 to adjust to x, then
(4450 - x) *0.50 + 0 * .5 = 3000
2225 - .5X = 3000
x = 1550
Low-Volatility Economy Probability Project Payoff Value of firm Value of equity Value of debt Bad 0.5 $ 3,600 $ 3,600 0 3600 Good 0.5 $ 3,850 $ 3,850 250 3600Related Questions
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