The Fountain Corp. estimates that the probability of a good business environment

Question

The Fountain Corp. estimates that the probability of a good business environment next year is equal to that of a bad business environment. The managers must choose between two mutually exclusive projects. It will be the only project done next year, so the payoff of the project is the value of the firm. The firm has to make a $500 payment to bondholders at the end of the eyar. The two projects are outlined below: 4. Low-risk Project Economy Good Bad High-risk Project Good Bad Probability .5 5 Project PayoffValue of Firm Value of StockValue of Bonds 700 500 200 700 500 500 500 300 .5 .5 800 100 800 100 500 100 Which project do shareholders prefer and why?

Explanation / Answer

shareholders will choose high risk project
as in bad scenario, their value is zero so they are indifferent between either project
in good scenario, they have higher value in high-risk project, so they would want high risk project

Hence, as in good scenario high risk is strictly dominating and in bad scenario high risk and low risk are equal..they would prefer high risk project

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

---

---

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