9. Fountain Corporation\'s economists estimate that a good business environment
ID: 2798435 • Letter: 9
Question
9. 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 S3,500 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 Economy Bad Good Probability .50 .50 Low-Volatility Project Payoff $3,500 3,700 High-Volatility Project Payoff $2,900 4,300 a. What is the expected value of the firm if the low-volatility project is undertaken? What if the high-volatility project is undertaken? Which of the two strategies maximizes the expected value of the firm? What is the expected value of the firm's equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken? Which project would Fountain s stockholders prefer? Explain. Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total firm value and opt for the high-volatility project. To minimize this agency cost, the firm's bondholders decide to use a bond covenant tExplanation / Answer
(a)
The expected return from low-volatility project when 50% volatility that economy can been good or bad.
E(LV) = 0.5*3,000 + 0.5*3,700 = 3,350
The expected return from high-volatility project when 50% volatility that economy can been good or bad.
E(HV) = 0.5*2,900 + 0.5*4,300 = 3,600
High-volatility project strategy will give the maximizing value of the organization.
(b) Equity Value = Company Value - Debt Value = 3,350 - 3,000 = $350
for undertaking low volatility project.
Equity Value = Company Value - Debt Value = 3,600 - 3,000 = $600
for undertaking high volatility project.
(c)
Stockholder will always go for taking extra risk project so that it can maximize their value in the company. So, they will prefer high volatility project.
(d) The bond holder will ask the premium price that is difference between the expected payoff of two project which is nothing but 600 - 350 = $250 to pay additionally so that two projects become indifferent to stockholders.
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