Sunburn Sunscreen has a zero coupon bond issue outstanding with a $12,000 face value that matures in one year. The current market value of the firmâs assets is $13,800. The standard deviation of the return on the firmâs assets is 34 percent per year, and the annual risk-free rate is 6 percent per year, compounded continuously. The firm is considering two mutually exclusive investments. Project A has an NPV of $1,500, and Project B has an NPV of $2,300. As the result of taking Project A, the standard deviation of the return on the firmâs assets will increase to 49 percent per year. If Project B is taken, the standard deviation will fall to 21 percent per year.
a-1: What is the value of the firmâs equity and debt if Project A is undertaken?
a-2: What is the value of the firmâs equity and debt if Project B is undertaken?
b: Which project would the stockholders prefer?
c: Suppose the stockholders and bondholders are in fact the same group of investors. Would this affect your answer to (b)?
Sunburn Sunscreen has a zero coupon bond issue outstanding with a $12,000 face value that matures in one year. The current market value of the firmâs assets is $13,800. The standard deviation of the return on the firmâs assets is 34 percent per year, and the annual risk-free rate is 6 percent per year, compounded continuously. The firm is considering two mutually exclusive investments. Project A has an NPV of $1,500, and Project B has an NPV of $2,300. As the result of taking Project A, the standard deviation of the return on the firmâs assets will increase to 49 percent per year. If Project B is taken, the standard deviation will fall to 21 percent per year.
a-1: What is the value of the firmâs equity and debt if Project A is undertaken?
a-2: What is the value of the firmâs equity and debt if Project B is undertaken?
b: Which project would the stockholders prefer?
c: Suppose the stockholders and bondholders are in fact the same group of investors. Would this affect your answer to (b)?
Related questions
| Sunburn Sunscreen has a zero coupon bond issue outstanding with a $20,000 face value that matures in one year. The current market value of the firmâs assets is $22,300. The standard deviation of the return on the firmâs assets is 42 percent per year, and the annual risk-free rate is 4 percent per year, compounded continuously. |
| Based on the BlackâScholes model, what is the market value of the firmâs equity and debt? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) |
| Market value | |
| Equity | $ |
| Debt | $ |
| Sunburn Sunscreen has a zero coupon bond issue outstanding with a $26,000 face value that matures in one year. The current market value of the firm's assets is $27,600. The standard deviation of the return on the firm's assets is 40 percent per year. |
| Frostbite Thermalwear has a zero coupon bond issue outstanding with a face value of $36,000 that matures in one year. The current market value of the firm's assets is $40,400. The standard deviation of the return on the firm's assets is 46 percent per year. |
| Suppose Sunburn Sunscreen and Frostbite Thermalwear have decided to merge. Because the two companies have seasonal sales, the combined firmâs return on assets will have a standard deviation of 21 percent per year, and the annual risk-free rate is 6 percent per year, compounded continuously. |
| a-1 | What is the combined value of equity in the two existing companies? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) |
| Equity | $ |
| a-2 | What is the combined value of debt in the two existing companies? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) |
| Debt | $ |
| b-1 | What is the value of the new firmâs equity? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) |
| Equity | $ |
| b-2 | What is the value of the new firmâs debt? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) |
| Debt | $ |
| c-1 | What was the gain or loss for shareholders? (A loss should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) |
| Gain/Loss | $ |
| c-2 | What was the gain or loss for bondholders? (A loss should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) |
| Gain/Loss |
| Fountain Corporationâs economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firmâs only activity and that the firm will close one year from today. Fountain is obligated to make a $3,700 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: |
| Economy | Probability | Low-Volatility Project Payoff | High-Volatility Project Payoff |
| Bad | .50 | $ 3,700 | $ 3,100 |
| Good | .50 | 4,000 | 4,600 |
a. What is the expected value of the firm if the low-volatility and high-volatility project is undertaken?
b. What is the expected value of the firmâs equity if the low-volatility and high-volatility project is undertaken?
c. Which project would Fountainâs stockholders prefer?
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 Fountain chooses to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects?
