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Investors and Other Stakeholders: practice question

Corporate Issuers · Investors and Other Stakeholders · Question ID corp-i02-1

Redveil Robotics has zero-coupon debt with a face value of $80 million due in one year. Its shareholders must choose between two mutually exclusive projects, neither requiring any further investment, each producing a single cash flow in one year, just as the debt matures. Project Calm pays $100 million for certain, while Project Storm pays $160 million with probability 0.5 and $40 million with probability 0.5. The increase in the expected year-end payoff to Redveil's shareholders from selecting Project Storm rather than Project Calm is closest to:

  1. $0 million
  2. $20 million
  3. $40 million
Show answer and explanation

Correct answer: B

Working: Shareholders receive max(0, cash flow − 80). Calm: 100 − 80 = $20m. Storm: 0.5 × (160 − 80) + 0.5 × 0 = $40m. Increase = 40 − 20 = $20 million.

Explanation: B is correct: shareholders hold the residual claim with the downside truncated at zero, so under Calm they expect 100 − 80 = $20 million, while under Storm they expect 0.5 × (160 − 80) + 0.5 × 0 = $40 million — a $20 million gain even though both projects have the same expected cash flow of $100 million; creditors' expected payoff simultaneously falls from $80 million to 0.5 × 80 + 0.5 × 40 = $60 million, so the shareholder gain is a pure wealth transfer from creditors (asset substitution). A is incorrect because an unchanged expected total cash flow does not keep the split between the fixed and residual claims unchanged — added volatility raises the residual's expected value when losses are capped at zero. C is incorrect because $40 million is the level of the expected payoff under Storm, not the increase of 40 − 20 = $20 million over Calm.

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Original, unofficial practice material; not a CFA Institute question.