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

1. Shareholder will be choosing project which will having any kind of probability of generation of higher income and that will be selecting project 2 because project 2 has probability of generation of Higher income because shareholder will be wanting the maximization of the value.

2 .debt holder of the company will be selecting project 1 because project 1 has certainity of inflow of cash and it is not having any uncertainty so debt holders will be assuring themself of not taking any unwanted risk.

3. Finance manager will be selecting project 2 because he would like to maximize the value of the organisation by taking a measured risk and he was not be liking to get additional debt exposure.