Sheaves Corporation economists estimate that a good business environment and a bad business environment are equally likely for the coming year. Management must choose between two mutually exclusive projects. Assume that the project chosen will be the firm€™s only activity and that the firm will close one year from today. The firm is obligated to make a $7,000 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:

a. What is the expected value of the firm if the low-volatility project is undertaken? What if the high-volatility project is undertaken? Which of the two strategies maximizes the expected value of the firm?

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?
c. Which project would the firm€™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 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?

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HIGH-VOLATILITY PROJECT PAYOFF LOW-VOLATILITY PROJECT PAYOFF PROBABILITY ECONOMY .50 .50 Bad $7,000 7,700 $6,300 8,300 Good