Dairy Isle has a value of $41,000 in a good economy and $32,000 in a recession.The firm has $35,000 of debt.The probability of a recession is 50 percent.The firm is considering a project that would change the firm values to $43,000 in a good economy and $29,000 in a recession.Will shareholders be willing to accept this project? Why or why not?
A)No;Because the project will lower firm value by $500
B)No;Because the project will lower shareholder value by $500
C)No;Because the firm will be worth less in a recession than it is currently
D)Yes;Because the project will increase both firm and shareholder value by $1,000
E)Yes;Because shareholder value will increase $1,000 at a cost of $1,500 to the bondholders

Question

Quizplus · Accepted Answer

Current firm value = .50 × $41,000 + .50 × $32,000 = $36,500Proposed firm value = .50 × $43,000 + .50 × $29,000 = $36,000Change in firm value = $36,000 - 36,500 = -$500Current shareholder value = .50 × ($41,000 - 35,000)+ .50 × $0 = $3,000Proposed shareholder value = .50 × ($43,000 - 35,000)+ .50 × $0 = $4,000Change in shareholder value = $4,000 - 3,000 = $1,000Current bondholder value = .5 × $35,000 + .5 × $32,000 = $33,500Proposed bondholder value = .5 × $35,000 + .5 × $29,000 = $32,000Change in bondholder value = $32,000 - 33,500 = -$1,500

Dairy Isle Has a Value of $41,000 in a Good