A firm has the choice of investing in one of two projects. Both projects last one year. Project 1 requires an investment of $11,000 and yields $11,000 with a probability of 0.5 and $13,000 with a probability of 0.5. Project 2 also requires an investment of $11,000 and yields $5,000 with a probability of 0.5 and $20,000 with a probability of 0.5. The firm is capable of raising $10,000 of the investment required through a bond issue carrying an annual interest rate of 10 percent.
i. Assuming that the investors are concerned only about expected returns, which project would stockholders prefer? Why?
ii. Which project would bondholders prefer? Why?
iii. In no more than five sentences, explain the importance of the CAPM as a tool in corporate finance.
iv. You are asked to value a corporate bond that pays a 12.3% coupon. Coupon payments are semiannual. The bond matures in 17 years. Your required rate of return to hold this bond is 10.3%. The par value of the bond is $1000. What is the value of this bond?