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7. Agency Costs Fountain Corporation's economists estimate that a good business environment and a bad business Page 552 environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm's only activity and that the firm will close one year from today. The company is obligated to make a $4,200 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 $4,200 $3,400 Good .50 4,600 4,900 a. What is the expected value of the company 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 company's equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken? c. Which project would the company'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 company chooses to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects? Chapter 17 Question 7 Input Area: Economy Bad Good Probability 0.50 $ $ Low-Volatility Project Payoff 4,200 $ 4,600 $ High-Volatility Project Payoff 3,400 4,900 Payment to bondholders $ 4,200 Output Area: Low-Risk Project Probability Project Payofti Firm value Equity value Debt value Bad Good High-Risk Project Probability Project Payofti Firm value Equity value Debt value Bad Good a. Expected value of firm: Low-volatility project High-volatility project b. Expected value of equity: Low-volatility project High-volatility project Stockholders would prefer project because the expected value of the equity is the (highest/lowest) d. Debt payment 7. Agency Costs Fountain Corporation's economists estimate that a good business environment and a bad business Page 552 environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm's only activity and that the firm will close one year from today. The company is obligated to make a $4,200 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 $4,200 $3,400 Good .50 4,600 4,900 a. What is the expected value of the company 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 company's equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken? c. Which project would the company'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 company chooses to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects? Chapter 17 Question 7 Input Area: Economy Bad Good Probability 0.50 $ $ Low-Volatility Project Payoff 4,200 $ 4,600 $ High-Volatility Project Payoff 3,400 4,900 Payment to bondholders $ 4,200 Output Area: Low-Risk Project Probability Project Payofti Firm value Equity value Debt value Bad Good High-Risk Project Probability Project Payofti Firm value Equity value Debt value Bad Good a. Expected value of firm: Low-volatility project High-volatility project b. Expected value of equity: Low-volatility project High-volatility project Stockholders would prefer project because the expected value of the equity is the (highest/lowest) d. Debt payment