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 dose one year from today. Fountain is obligated to make a $4,200 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.) Expected value of the firm Low-volatility project value $ High-volatility project value $ 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.) Expected value of the firm's equity Low-volatility project value $' High-volatility project value $ Which project would Fountain's stockholders prefer? High-volatility project Low-volatility project 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? (Do not round intermediate calculations. Enter your answer in whole dollars.)

Explanation / Answer

Solution: Expected Value of a Firm = Sum of (Probablity x Payoff) (a) Economy probability Low vol payoff High vol Payoff P x Low P x High Bad 0.5 4200 3600 2100 1800 Good 0.5 4750 5350 2375 2675 Total 4475 4475 Expected value of firm: Low volatility project = 4475 High volatility project = 4475 (b) Value of equity = value of firm – value of debt Low volatility project = 4475 -4200 = 275 High volatility project = 4475 -4200 = 275 (c ) As Equity shareholder wants to maximise value of equity only and not the value of firm, so They will surely opt for high Volatality project. Note : Though here low and high volatality project gives same return, so does not make differece,but equirt shareholder always prefer high volatality project. (d) Since, both the firms have the same value. Choosing any project will not affect. Therefore existing payment of $4200, to bondholder would make stockholders Indifferent between two project.

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