issCe wil this statement? 7. Agency Costs Fountain Corporation\'s economists est

Question

issCe wil this statement? 7. Agency Costs 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 firm's only activity and that the firm will close one year from today. The company is obligated to make a $3,500 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: High-Volatility Probability .50 .50 Low-Volatility Project Payoff $3,500 3,700 Project Payoff $2,900 4,300 Economy Bad Good 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

1) Low-volatility project value = 0.50($3,500) + 0.50($3,700) $3,600 High-volatility project value = 0.50(2,900) + 0.50($4,300) $3,600 Both the low-volatility project and High - volatility project have the same expected value of the firm so both are are equal 2) Expected value of equity with low-volatility project = 0.50($3500 - 3500) + 0.50($3700-3500) $100 Expected value of equity with high-volatility project = 0.50(2900 - 3500) + 0.50($4300-3500) 400 3) The company stockholders will prefer the high volatility project since it maximizes the expected value of the company’s equity.

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