high volatility project is undertaken? (Do not round intermediate calculations project is undertaken? What and round your answers to the nearest whole dollar, e.g., 32.) What is the expected value of the firm's equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken? (Do not round intermediate calculations and round your answers to the nearest whole dollar, e.g., 32.) Which project would the firm's stockholders prefer? 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 firm's bondholders decide to use a bond covenant to ipulate that the bondholders can demand a higher payment if the firm chooses to ke on the high-volatility project. What payment to bondholders would makn ockholders indifferent between the two
high volatility project is undertaken? (Do not round intermediate calculations project is undertaken? What and round your answers to the nearest whole dollar, e.g., 32.) What is the expected value of the firm's equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken? (Do not round intermediate calculations and round your answers to the nearest whole dollar, e.g., 32.) Which project would the firm's stockholders prefer? 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 firm's bondholders decide to use a bond covenant to ipulate that the bondholders can demand a higher payment if the firm chooses to ke on the high-volatility project. What payment to bondholders would makn ockholders indifferent between the two
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Concept explainers
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Question
Transcribed Image Text:firm's only activity and that the firm will close one year from today. The firm is obligated
to make a $3,700 payment to bondholders at the end of the year. The projects have the
same systematic risk, but different volatilities. Consider the following information
pertaining to the two projects:
Low-Volatility High-Volatility
Economy Probability Project Payoff Project Payoff
Bad
.50
$3,700
$3,100
Good
.50
4,000
4,600
a. What is the expected value of the firm if the low-volatility project is undertaken? What
if the high-volatility project is undertaken? (Do not round intermediate calculations
and round your answers to the nearest whole dollar, e.g., 32.)
b. What is the expected value of the firm's equity if the low-volatility project is
undertaken? What is it if the high-volatility project is undertaken? (Do not round
intermediate calculations and round your answers to the nearest whole dollar, e.g.,
32.)
c. Which project would the firm's stockholders prefer?
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 firm's bondholders decide to use a bond covenant to
stipulate that the bondholders can demand a higher payment if the firm chooses to
take on the high-volatility project. What payment to bondholders would make
stockholders indifferent between the two projects? (Do not round intermediate
calculations and round your answer to the nearest whole dollar, e.g., 32.)
a. Low-volatility project value
High-volatility project value
b. Low-volatility project value
High-volatility project value
C. Stockholders preference
d. Payment to bondholders
$
$
$
3,850
3,850
150
High-volatity project
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