Question

Fountain Corporation economists estimate that the probability of a good business environment next year is equal to the probability of a bad environment. Knowing this, the managers of Fountain must choose between two mutually exclusive projects. Suppose the payoff from the chosen project is the only future cash flow expected by the firm. (The firm will cease to exist after the payoff from the project.) Fountain is obliged to make a $500M payment to its bondholders next year. Here is a description of the projects:

	Probability	Project 1 Payoff	Project 2 Payoff
Boom	0.5	500M	100M
Recession	0.5	700M	800M

Which project would maximize the total value of the firm? Which project would shareholders prefer? Please provide explanations and calculations.

Answer 1