Suppose the firm in the previous problem is considering two mutually exclusive investments. Project A has an NPV of $2,400 and Project B has an NPV of $2,800. As a result of taking Project A, the standard deviation of the return on the firm’s assets will increase to 49 percent per year. If Project B is taken, the standard deviation will fall to 26 percent per year.

a. What is the value of the firm’s equity and debt if Project A is undertaken? If Project B is undertaken?

b. Which project would the stockholders prefer? Can you reconcile your answer with the NPV rule?

c. Suppose the stockholders and bondholders are, in fact, the same group of investors. Would this affect your answer to part (b)?

d. What does this problem suggest to you about stockholder incentives?