Question

A firm is considering two mutually exclusive projects (named A and B). The cash flows in each of two states of the worlds are provided for each of the projects. The projects cost the same.

	Project A		Project B
	Boom	Recession	Boom	Recession
Probability	0.6	0.4	0.6	0.4
Cash flow	$200	$100	$220	$60
Payment to debt holders	$100	$100	$100	$50
Distribution to stockholders	$100	$0	$120	$10

In the scenario described above:

A) Shareholders will ask managers to choose value maximizing project A and there will be no conflict between shareholders and bondholders.

B) Shareholders will ask managers to choose project B and there will be a conflict between shareholders and bondholders.

C) Bondholders will prefer project B.

D) Bondholders will be indifferent between project A and B because they only get a fixed return.

E) None of the above is correct.

Answer 1

Answer is B. Shareholders will ask managers to choose project B and there will be conflict between shareholders and bondholders
Explanation:
As discussed earlier, The stockholders will receive the higher cash flows in project B rather than Project A i.e. 76 instead of 60.
And bondholders will receive higher cashflows in Project A rather than project B.
Thus, stockholders prefer Project B.
There is a conflict in the interest of stockholders and bondholders.