Reference no: EM13730608
Lima Inc. can choose between two mutually exclusive projects, both costing 2,700,000 and both having a one-year life.
Assume that all agents are risk neutral, and that the risk-free rate is 3%. The economic conditions in the upcoming year can be either good or bad. The first project has low payoff volatility and the second project has a high payoff volatility. The payoff characteristics are as followed:
Situation Probability Low Volatility Project Payoff High Volatility Project Payoff
BAD 0.6 2,500,000 1,400,000
GOOD 0.4 3,750,000 5,250,000
Assume that the company needs to fund 90% of the initial investment by issuing a zero coupon bind with maturity 1 year
a) What is the face value of the zero coupon bond if debt holders believe that the low volatility project will be undertaken? What is the face value of the zero coupon bond if debt holders believe that the high volatility project will be undertaken?
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