Question

Suppose there are two potential projects for investment. Project 1 has a certain payoff of $50 in one year, while project 2 has a 50% chance of generating $100 in one year, and another 50% chance of generating $0 in one year. Suppose the company has an outstanding debt = $50.
(1)Which project will shareholders prefer? Justify your answer.
(2)Which project will debt holders prefer? Justify your answer.
(3)Which project will the financial manager prefer? Justify your answer

Answer 1

Answer:

Explanation:

Project A:

Has a certain payoff of $50 in 1 year

Project B:

Has a 50% chance (0.5 probability) of generating $100 in a year and the remaining 50% probability that it generates $0 in a year.

Also, the company has an outstanding debt of $50.

(1) Which project will shareholders prefer?

Shareholders will prefer Project B

Why?

A shareholder is not a salary earner or employee in the firm. The focus of a shareholder is dividends. Dividends come to shareholders when the company makes good sales or profits. Now, business isn't good all the time (internal and/or external factors affect profits either positively or negatively, at different times). Shareholders will prefer to benefit from the 50% probability case of $100 generation and also lay low if the other probability of $0 occurs.

(2) Debt holders will prefer Project A.

Because a $50 payoff is sure every year, in Project A, debt holders will prefer Project A. If project B were to be invested in and the $0 probability occurs, debt holders will be held strongly to pay their debts.

(3) Which project will the financial manager prefer?

Project B

Why?

Because if $100 is made in a year, he/she will be able to plan with it, and gauge the company for when there'll be $0 generation.