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 $12,000 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 highvolatility 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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Low-Volatility Project Payoff High-Volatility Project Payoff Economy Probability Bad .50 $12,000 $11,400 Good .50 12,800 13,300