In this paper, we will apply the concepts of financial management to a real world problem. According to the instructions, MarCher company considers an opportunity to invest money in a new risky project. The company has to choose between two possible options: to invest in a high-risk project or to invest in a low-risk project. Also, there are two possible outcomes of the investment – the projects may either boom or bust. Both projects produce different cash flows under two possible outcomes that are given in the table below:
The company is short of $870,000 to finance these projects and will owe $900,000 in one year. According to some financial analytics, the chance of boom is 60% and the chance of bust is 40% for both projects.
The first part of the analysis is to calculate the expected value of profit (loss) for both projects, in case if the company remains unlevered. The expected value of project cash flows is related to expected value in probability theory. It is equal to the sum of he products of the impacts and the probabilities of these impacts (Pmpmath.com, 2016). The expected value of a high-risk project is calculated below:
EV1=1500000*0.6+400000*0.4=1,060,000
As the results indicate, a high-risk project is expected to produce a profit.
The expected value of a low-risk project is calculated below:
EV2=1000000*0.6+500000*0.4=800,000
A low-risk project is expected to produce a profit too.
We know that risk-neutral investors, such as stockholders, usually prefer strategy with the highest expected value. In this case, stockholders would prefer project #1 (a high-risk project), because it produces higher expected profit.
The next step of the project is to calculate the expected value of both projects, assuming MarCher Industries borrow $870,000 to partially finance their investment and will owe $900,000 in one year. The expected value of a high-risk project is calculated below:
EV1=1500000*0.6+400000*0.4-900000=160,000
As the results indicate, a high-risk project is expected to produce a profit.
The expected value of a low-risk project is calculated below:
EV2=1000000*0.6+500000*0.4-900000=-100,000
A low-risk project is expected to produce a loss.
In this case, stockholders would prefer a high-risk project, while bondholders would prefer a low-risk project.
The conflict between shareholders and bondholders comes from their different rights. They have different returns and prefer to take projects with different risks ("Conflicts of Interest Between Shareholders and Bondholders", 2015). The stockholders are the company’s owners, while the creditors are bondholders. Since stockholders receive the difference between cash flow at project expiration and debt-service payment (principal and interest), they are more interested in riskier projects. However, bondholders as creditors are not interested in higher profit of the projects. They are always interested in project with low risk. In case of the successful risky project, stockholders will take all the profits, however, if the project will fail, all losses may be distributed with bondholders. If the high risky project fails, it will produce less money than if a low-risk project fails. Hence, bondholders support a low-risk project. To avoid risks related to the choice of the project, bondholders may initiate contracts that prohibit managers to take risky decisions (What is Finance?, 2014).
References
Conflicts of Interest Between Shareholders and Bondholders. (2015). Boundless. Retrieved from https://www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-the-field-and-goals-of-financial-management-1/agency-and-conflicts-of-interest-28/conflicts-of-interest-between-shareholders-and-bondholders-168-3834/
Pmpmath.com. (2016). PMP | MATH. Retrieved 14 February 2016, from http://www.pmpmath.com/emv.php
What is Finance?. (2014). Conflicts between Managers, Stockholders and Bondholders. Retrieved 14 February 2016, from http://whatisfinance.org/conflicts-between-managers-stockholders-and-bondholders/
