Fountain Corporation's economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between 2 mutually exclusive projects. Assume that the project the company chooses will be the company's only activity and that the company will close one year from today. The company is obligated to make a $4,700 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: Economy Probability Low-Volatility Project Payoff High-Volatility Project
Payoff
Bad .50 $4,700 $4,100
Good .50 5,500 6,100
a. What is the expected value of the company if the low-volatility project is undertaken? The high-volatility project?
b. What is the expected value of the company's equity if the low-volatility project is undertaken? The high-volatility project?
c. Which project would the company's stockholders prefer?