Investment depends on the strength

Reference no: EM131035579

Bedrock Company has $70 million in debt and $30 million in equity. The debt matures in one year and has a 10% interest rate, so the company is promising to pay back $77 million to its debt holders one year from now
The company is considering two possible investments, each of which will require an upfront cost of $100 million. Each investment will last for one year and the payoff from each investment depends on the strength of the overall economy. There is a 50% chance that the economy will be weak and a 50% chance it will be strong
Here are the expected payoffs (all dollars are in millions) from the two investments:

Note that the two projects have the same expected payoff, but Project H has higher risk. The debt holders always get paid first and the stockholders receive any money that is available after the debt holders have been paid
Assume that if the company doesn't have enough funds to pay off its debt holders one year from now, then Bedrock will declare bankruptcy. If bankruptcy is declared, the debt holders will receive all available funds and the stockholders will receive nothing.
a. Assume that the company selects Investment L. What is the expected payoff to the firm's debt holders? What is the expected payoff to the firm's stockholders?

b. Assume that the company selects Investment H. What is the expected payoff to the firm's debt holders? What is the expected payoff to the firm's stockholders?

c. Would the debt holders prefer that the company's managers select Project L or Project H? Briefly explain your reason.

d. Explain why the company's managers acting on behalf of the stockholders might select Project H even though it has greater risk.

e. What actions can debt holders take to protect their interests?

Reference no: EM131035579

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