Debtholders prefer different projects from shareholders. In the following scenario, which group will support which project?Project A has a guaranteed payoff of $200 million, which will exactly...

Debtholders prefer different projects from shareholders. In the following scenario, which group will support which project?

Project A has a guaranteed payoff of $200 million, which will exactly compensate the debtholders of the firm. Project B has a 50% probability of a $400 million payoff and a 50% probability of a zero payoff. Debtholders would support one of these projects and not the other. Shareholders would support one of these projects over the other.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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In this case, debtholders would support Project A while shareholders would support Project B.

Project A is risk-free.  It will certainly pay off the debtholders.  Therefore, they will support it.  This is particularly true because in Project B, they have a 50% chance of getting nothing and a 50% chance of getting paid back.  In Project A, they have a 100% chance of getting paid.  If Project B succeeds, they don't get any more money than they would in Project A.  So why gamble?

But Project A does shareholders no good.  The income will only be enough to pay the debtholders with nothing left to pay out in dividends.  So, in Project A, shareholders have a 100% chance of getting nothing.  At least in Project B they have a 50% chance of splitting $200 million (what's left after the debts are paid) between them.

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