The Circular File Company has the option to embark upon a project that costs $10
ID: 2749189 • Letter: T
Question
The Circular File Company has the option to embark upon a project that costs $10 with a PV of $9 (i.e. NPV = $ - 1). The Firm's bylaws state that it will never issue preferred stock. The firm's balance sheet is as follows: Under what conditions would the project be beneficial to the equity shareholders? Under what conditions would the project be beneficial to the bondholders? If your answers for A and B are the same, describe why they are the same. If your answer for A and B are the different, describe why they are the different.Explanation / Answer
a.
Under the market value condition the project is beneficial to the equity shareholders.
b.
Under the book value condition the project is beneficial to the bondholders.
c.
Since the project has negative NPV, it will affect directly to the return on equity shareholders. Their returns will reduce in future. Therefore, they want their shares to be evaluated on market price so that they can take the decision of holding or selling shares currently.
Bondholders payments are almost assured. Success or failure of project has no impact on their income. They not even want to look on the market value but will wait till maturity. Therefore, they prefer book value type for keeping records.