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

Question

4. The Fountain Corp. estimates that the probability of a good business environment next year is equalto that of a bad business environment. The managers must choose betweentwomutually exclusive projects. It will bethe only project done next year, sothe payoff of the project is the value of the firm. The firm hasto make a $500 paymentto bondholders at the end of the year Thetwo projects are outlined below Low-risk Project Econom Good Bad High-risk Project Good Bad Probabilit Project PayoffValue of Firm Value of Stock Value of Bonds 700 500 700 500 500 500 200 800 100 800 100 500 100 300 Which project do shareholders prefer and why?

Explanation / Answer

Value of low risk project equity = 0.5 * 200 + 0.5 * 0 = 100

Value of high risk project equity = 0.5 * 300 + 0.5 * 0 = 150

For shareholder high risk project has high equity value.

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