Use the following information to answer the question(s)below.
If managed effectively,Rearden Metal will have assets with a market value of $200 million,$300 million,or $400 million next year,with each outcome being equally likely.Managers,however,may decide to engage in wasteful empire building,which will reduce Rearden's market value by $20 million in all cases.Managers may also increase the risk of the firm,changing the probability of each outcome to 50%,5%,and 45% respectively.
-Suppose that the managers at Rearden Metal will increase risk to maximize the expected payoff to equity holders.If Rearden has $180 million in debt due in one year,then the expected value of Rearden's assets is closest to:

Question

Quizplus · Accepted Answer

To maximize the expected payoff, managers will choose the option with the highest expected value. The expected value of the assets without empire building is (0.5*200)+(0.05*300)+(0.45*400) = $277.5 million. With empire building, the expected value of the assets is (0.5*(200-20))+(0.05*(300-20))+(0.45*(400-20)) = $279.5 million. However, since the company has $180 million in debt due in one year, the equity holders will only receive the value of the assets minus the debt, which is $279.5 million - $180 million = $99.5 million. Therefore, the expected value of Rearden's assets is $300 million ($99.5 million equity plus $180 million debt). The closest answer is C.

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