A firm has the choice of investing in one of two projects. Both projects last for one year. Project 1 requires an investment of $11,000 and yields $11,000, with a probability of 0.5, and $13,000, with a probability of 0.5. Project 2 also requires an investment of $11,000 and yields $5,000, with a probability of 0.5, and $20,000, with a probability of 0.5.
The firm is capable of raising $10,000 of the required investment through a bond issue that carries an annual interest rate of 10 percent.
Assuming that the investors are concerned only about expected returns, which project would stockholders prefer? Why? Which project would bondholders prefer? Why?