Fountain Corporation economists estimate that the probability of a good business environment next year is equal to the probability of a bad environment. Knowing this, the managers of Fountain must choose between two mutually exclusive projects. Suppose the payoff from the chosen project is the only future cash flow expected by the firm. Fountain is obliged to make a $1000 payment to its bondholders next year. Here is a description of the projects:
Low Risk Project
Probability Payoff Value of Stock Value of Bonds
Recession .5 1000 0 1000
Boom .5 1400 400 1000
High Risk Project
Probability Payoff Value of Stock Value of Bonds
Recession .5 200 0 200
Boom .5 1600 600 1000
Which project will the stockholders prefer? Which project maximizes the value of the firm? Why are these answers different?