22 Jul WHAT PAYMENT TO BONDHOLDERS WOULD MAKE STOCKHOLDERS INDIFFERENT BETWEEN THE TWO PROJECTS?
s economists estimate that a good business environment and a bad business e Show more Fountain Corporations 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 firms only activity and that the firm will close one year from today. Fountain is obligated to make a $5000 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 Probability Low-Volatility Project Payoff High-Volatility Project Payoff Bad .50 $ 5000 $ 4400 Good .50 5950 6550 a. What is the expected value of the firm if the low-volatility and high-volatility project is undertaken? (Do not round intermediate calculations. Enter your answers in whole dollars.) Expected value of the firm Expected value of the firm Low-volatility project value $ High-volatility project value $ b. What is the expected value of the firms equity if the low-volatility and high-volatility project is undertaken? (Do not round intermediate calculations. Enter your answers in whole dollars.) Expected value of the firms equity Expected value of the firms equity Low-volatility project value $ High-volatility project value $ c. Which project would Fountains stockholders prefer? High-volatility project Low-volatility project d. 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 firms bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if Fountain chooses to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects? Show less
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