Project A or B: Debtholders and Shareholders
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Scenario: Project A has a guaranteed a payoff of $200 million, which will exactly compensate the debtholders of the firm. Project B has a 50 percent probability of a $400 million payoff and a 50 percent probability of a zero payoff. Which project do the debtholders prefer and which project do the shareholders prefer?
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Solution Summary
The expected returns and the risks from the two projects are computed. Based on the results, the solution provides a detailed explanation of the preferences of the debtholders and shareholders. This is all completed in about 220 words, with calculations provided.
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As a first step, the expected returns from the two projects are computed:
Project A - Expected Return = $ 200 million (guaranteed)
Project B - Expected Return = (0.5 * $ 400 million) + (0.5 * $ 0)
= $ 200 million
The risks associated with these projects:
Project A - Standard Deviation = Sq.Rt. [1 * ...
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