Suppose a firm is considering two mutually exclusive investments. Project A has

Question

Suppose a firm is considering two mutually exclusive investments. Project A has a NPV of $1.3 million and Project B has a PV of $1.2 million. As a result of taking Project A, the standard deviation of the return on the firm's assets will fall to 40 percent per year. If Project B is taken, the standard deviation will rise to 50 percent per year. a. Which project would the stockholders prefer? b. Suppose the stockholders and bondholders are, in fact, the same group of investors. Would this affect your answer to a?

Explanation / Answer

a) Stockholders will prefer Project A as it has higher NPV than Project B.

b) Bondholders typically prefer projects with lower risk, i.e. standard deviation. In this case, as Project A reduces the standard deviation, both stockholders and bondholders would prefer Project A over Project B.

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