Reference no: EM13225522

Foundation corporation's economists estimate that a good business environment and a bad business enviornment are equally likely for the coming year. The managers 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 $3,500 payment to bondholders at the end of the year. The project has the same systematic risk but different volatilities. Consider the following information pertainining to the two projects.

Economy Probability Low Volatility Project Payoff    High Volatility Project Payoff
Bad                             0.5            $3,500.00          $2,900
Good                           0.5             $3,700.00         $4,300

A) What is the expected value of the firms if the low-volatility project is undertaken? What is the high volatility project is undertaken? What of the two strategies maximizes the expected value of the firm?

B) What is the expected value of the firm equity if the low-volatility project is undertaken? What is it if the high-volatility is undertaken?

C) Which project would fountain's stockholders prefer? Explain.

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 choose to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects? (Show forumla for calculations)