After three fourteen-hour days of intense meetings, two proposals emerged.

In the first proposal, FOY would immediately cease funding all R&D activities and shut down its R&D division. This action would essentially make FOY look like the old Benson Labs without the divisions that had been spun off by ITM. There would be $25 million in upfront costs to shut down the R&D division, but the action would generate $75 million over each of the next four years. These savings were considered to be low risk and would be discounted at a required rate of return of 8%. Cash flow volatility would decline to 20%. In this scenario, FOY would have a reasonable chance to pay of the bonds if they ran a tight ship and sold off some assets, but the company would essentially be like a stripped-down and lower valued version of Benson Labs with no substantial growth opportunities.

The second proposal called for investing $90 million of the existing cash to redirect R&D activities toward a project that could lead to a blockbuster patent within four years. FOY could then sell this patent to generate the cash to cover the bond payments and have cash left over to rebuild shareholder value. The odds of success were low. Foy expected was that there would be no cash flows for three years and only $100 million in cash flows in year four. However, the volatility of these cash flows was 80%, so there was some probability that the project could pay off in a big way. As this proposal was considered very risky, the required rate of return was 20%

After some discussion of the merits of both projects, the Lead Independent Director reminded everyone that they should choose the project that is in the best interests of the shareholders. Everyone agree, and they asked an analyst to estimate how each project would impact the value of equity and the value of the debt.

Use an option framework to estimate the impact of each project on the value of the equity and the value of the debt. Which project would shareholders prefer? Which project would bondholders prefer? Justify your answer with analysis and provide the details of your estimation.