Lima inc. can choose between two mutually exclusive projects, both costing 2,700,000, and both having a one-year life. Assume that all agents are risk neutral, and that the risk-free rate is 3%. The economic conditions in the upcoming year can either be good or bad. The first project has a low payoff volatility, and the second has a high payoff volatility. The payoff characteristics are reported as the following:
Situation| Probability| Low volatility payoff| High volatility payoff
Bad 0,6 2,500,000 1,400,000
Good 0,4 3,750,000 5,250,000
Assume that the company needs to fund 90% of the initial investment by issuing a zero coupon bond with maturity of one year.
a) Assume that debt holders believe that the low volatility project will be undertaken. What is the value of the firm’s equity at time 0 if the high volatility project is undertaken? What is the value of the firm’s equity at time 0 if the low volatility project is undertaken? Which project maximizes the value of the equity at time 0?
Have been stuck on this for a while and would really like som advice and/or help! Thanks in advance:)
