The managers of a firm are asked to consider two possible new product lines for the firm. Project 1 is quite risky and may result in a market value for the firm of $50 million in two years, or nothing. Project 2 is much more certain in outcome and may result in a firm market value as high as $25 million or as low as $15 million.
The face value of the company’s debt, payable in two years, is $20 million.
a. What are the possible payoffs to the bondholders under projects 1 and 2?
b. What are the possible payoffs to the shareholders under projects 1 and 2?
c. Which will the shareholders favor? The bondholders?
a. What are the possible payoffs to the bondholders under projects 1 and 2?
PROJECT 1:
Total Payoff Debt Distribution
50 20
0 0
PROJECT 2:
Total Payoff Debt Distribution
25 20
15 15
b. What are the possible payoffs to the shareholders under projects 1 and 2?
Answer: (Payoffs in 2 years, in millions of dollars)
PROJECT 1:
Total Payoff Equity Distribution
50 30
0 0
PROJECT 2:
Total Payoff Equity Distribution
25 5
15 0
c. Which will the shareholders favor? The bondholders?
Answer: Shareholders will favor project 1, which provides an equal or higher payoff in each state. Bondholders favor project 2 for the same reason.
