What payment must bondholders require of stockholders

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Agency Costs: Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm’s only activity and that the firm will close one year from today. Fountain is obligated to make a $3,500 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-Volatility Project Payoff High-Volatility Project Payoff Bad 0.50 $3,500 $2,900 Good 0.50 $3,700 $4,300 Suppose bondholders rationally assume that because management is motivated with equity-based compensation, they will choose to maximize equity value rather than total firm value. What payment must bondholders require of stockholders in order to make stockholders indifferent between the two projects?

Reference no: EM132071891

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