5. 17.

Equity as an option and NPV [LO 25.4] Suppose the firm in Problem 16 is considering two mutually exclusive investments. Project M has an NPV of $1 900 and Project P has an NPV of $2 800. As the result of taking Project M, the standard deviation of the return on the firm’s assets will increase to 46 per cent per year. If Project P is taken, the standard deviation will fall to 29 per cent per year.

1. What is the value of the firm’s equity and debt if Project M is undertaken? If Project P is undertaken?

2. Which project would the shareholders prefer? Can you reconcile your answer with the NPV rule?

3. Suppose the shareholders and debtholders are in fact the same group of investors. Would this affect your answer to (b)?
4. What does this problem suggest to you about shareholder incentives?