Fountain Corporation’s economists estimate that a good business environment and
ID: 2788527 • 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 $3,500 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:
Low-Volatility Project Payoff
Suppose bondholders rationally assume that because management is motivated with equity-based compensation, they will choose to maximize equity value rather than total firm value. What payment must bondholders require of stockholders in order to make stockholders indifferent between the two projects?
A. $4,000
B. None of these values are correct
C. $3,600
D. $3,800
Economy ProbabilityLow-Volatility Project Payoff
High-Volatility Project Payoff Bad 0.50 $3,500 $2,900 Good 0.50 $3,700 $4,300Explanation / Answer
expected value of low volatility project = 0.5 * 3500 + 0.5 * 3700
= 3600
expected value of high volatility project = 0.5 * 2900 + 0.5 * 4300
=3600
share holder earning during bad condition = 3500-3500 =0
share holder earnings during good = 3700 -3500 = 200
total value of equity = 0.5 *0 + 0.5 * 200 = 100
to make stockholders indifferent , the bondholders will need to raise their required debt payment
expected value of equity of loqw volatile project
=>
100 = 0.5 *0 + 0.5 * (4300 -x)
=>
X = 4100
hence debt is 41100 for high volatility project
choose B)
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