Question: 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,

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 a 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?

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