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1. 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?

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