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 firm’s assets is $13,800. The standard deviation of the return on the firm’s 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 firm’s 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 firm’s equity and debt if Project A is undertaken?
a-2: What is the value of the firm’s 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)?