Dairy Isle has a value of $59,000 in a good economy and $48,000 in a recession.The firm has $50,000 of debt.The probability of a recession is 32 percent.The firm is considering a project that would change the firm values to $63,000 in a good economy and $46,000 in a recession.Which one of these statements correctly describes the effects of this project?
A)The bondholders and stockholders equally share the increase in firm valuation.
B)The bondholders are unaffected by the project.
C)The shareholders gain an amount equal to 68 percent of the increase in the firm's value.
D)The shareholders gain $2,080 while the bondholders are unaffected.
E)The project transfers $640 from bondholders to stockholders.

Question

Quizplus · Accepted Answer

Current firm value = (1 - 0.32)$59,000 + 0.32($48,000)= $55,480
Proposed firm value = (1 - 0.32)$63,000 + 0.32($46,000)= $57,560
Change in firm value = $57,560 - $55,480 = $2,080
Current shareholder value = (1 - 0.32)($59,000 - $50,000)+ 0.32($0)= $6,120
Proposed shareholder value = (1 - 0.32)($63,000 - $50,000)+ 0.32($0)= $8,840
Change in shareholder value = $8,840 - $6,120 = $2,720
Current bondholder value = (1 - 0.32)($50,000)+ 0.32($48,000)= $49,360
Proposed bondholder value = (1 - 0.32)($50,000)+ 0.32($46,000)= $48,720
Change in bondholder value = $48,720 - $49,360 = -$640

Dairy Isle Has a Value of $59,000 in a Good