Illustrate that this in expectation decreases firms value

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A struggling company currently has a net worth of $700,000. It owes $500,000 from debt financing (assume these are loans from the bank if you wish). The value of the company to the owners is the difference between the net worth and the amount owed to the debt holders. What is the current value of the firm to the owners?

Now assume that a project is presented to the owners that results in a loss of the entire worth of the company with a probability of 50% and results in a gain of $500,000 with probability 50% (resulting in a net worth of $1,200,000). Show that this in expectation decreases the firm's value, and explain why, in spite of that, the owners of the company would want to undertake the project.

Reference no: EM13392273

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