Equity as an Option and NPV: Suppose the firm in the previous problem is considering two mutually exclusive investments. Project A has an NPV of $1,900, and Project B has an NPV of $2,800. As the result of taking Project A, the standard deviation of the return on the firm's assets will increase to 46 percent per year because it is riskier and has lower NPV. If Project B is taken, the standard deviation will fall to 29 percent per year.
a. What is the value of the firm's equity and debt if Project A is undertaken? If Project B is undertaken?
b. Which project would the stockholders prefer? Can you reconcile your answer with the NPV rule?
c. Suppose the stockholders and bondholders are in fact the same group of investors. Would this affect your answer to (b)?
d. What does this problem suggest to you about stockholder incentives? How in the real world bondholders can prevent this?