Fountain Corporation’s economists estimate that a good business environment and

ID: 2783205 • 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 the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the company’s only activity and that the company will close one year from today. The company is obligated to make a $4,300 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 company if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.)

What is the expected value of the company’s equity if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.)

Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total company value and opt for the high-volatility project. To minimize this agency cost, the company's bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if the company 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 and round your answer to the nearest whole number, e.g., 32.)

Explanation / Answer

Economy Probablity Low-volatality project payoff Expected Low-volatality project payoff High-volatality project payoff Expected High-volatality project payoff Bad 0.5 4300 2150 3700 1850 Good 0.5 4900 2450 5500 2750 4600 4600 a.Expected value of company High-volatality 4600 Low-volatility 4600 b.Expected value of equity High-volatality =4600-4300=300 Low-volatility =4600-4300=300 c. The stockholders will be indifferent as the expected payoff remains the same in both cases. d. There is no difference in the outcomes of both the projects. Hence the equity shareholders are already indifferent. Please hit the like button if the answer helped you else leave a comment for further clarification. Thank you! All the best!

Navigate

Fountain Corporation’s economists estimate that a good business environment and

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

Fountain Corporation’s economists estimate that a good business environment and

Question

Explanation / Answer

Related Questions

Navigate