Fountain corporation economists estimate that the

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Fountain Corporation economists estimate that the probability of a good business environment next year is equal to the probability of a bad environment. Knowing this, the managers of Fountain must choose between two mutually exclusive projects. Suppose the payoff from the chosen project is the only future cash flow expected by the firm. Fountain is obliged to make a $1000 payment to its bondholders next year. Here is a description of the projects:

Low Risk Project

Probability Payoff Value of Stock Value of Bonds

Recession .5 1000 0 1000

Boom .5 1400 400 1000

High Risk Project

Probability Payoff Value of Stock Value of Bonds

Recession .5 200 0 200

Boom .5 1600 600 1000

Which project will the stockholders prefer? Which project maximizes the value of the firm? Why are these answers different?

Reference no: EM13380846

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