7. Agency Costs Rountain Corporation\'s economists estimate that a good business

Question

7. Agency Costs Rountain Corporation's economists estimate that a good business environment and a bad business environment are equally likely for the coming yeai. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm's only activity and that the firm will close one ycar from today The company is obligated to make a $3,500 payment to bondholders at the end of the yeat The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Bad Good Probability 50 50 Low-Volatility Project Payoff $3,500 3,700 High-Volatility Project Payoff $2,900 4,300 a. what is the expected value of the company if the low-volatility project is undertaken? What if the high-volatility project is undertaken? Which of the two strategies maxi- mizes the expected value of the firm? b. What is the expected value of the company's equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken?

Explanation / Answer

a) Expected value: probablity * pay offs.

Expected value of all projects are illustrated below.

Therefore project with high pay off in good economy maximises the expected value of the firm as it has the highest expected value.

b) expected value of company equity for all the projects are illustrated below.

c) company stock holders would prefer project with low volatility because in either economy it fetches stabilised returns.

d) they may have to chose affirmative covenant. They can use some average fixed payment or limit order to reduce the risk of volatality.

Low pay off High pay off Bad $175,000.00 $145,000.00 Good $185,000.00 $215,000.00

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