A. Consider the following risky scenarios for future cash flows for a firm:

Project 1 Project 2

Probability Cash Flow ($) Probability Cash Flow ($)

0.3 2,000 1/3 -7,000

0.5 4,000 1/3 5,000

0.2 6,000 1/3 4,000

Given that the firm has fixed debt payments of $3,000 and limited liability, which scenario (project) will shareholders choose and why?

B. You have estimated the following probabilities for earnings per share of companies A and B:

Probability A ($/share) B ($/share)

0.1 0.5 1.0

0.2 1.5 1.5

0.4 2.0 2.5

0.3 2.5 4.0

Compare companies A and B, using the stochastic dominance criteria. Would your answer be the same if you were asked to use the mean-variance criterion? (10 marks)