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Project Selection and Shareholder Incentives
A corporation, which operates under a legal framework that protects its owners' personal assets from business debts, has $1 million in assets and owes a bank $900,000. The shareholders' total investment in the company is $100,000. The company must choose one of the following two projects:
- Project A (Low-Risk): Has a 100% probability of generating a $50,000 profit.
- Project B (High-Risk): Has a 20% probability of generating a $2 million profit, but an 80% probability of losing all the company's assets ($1 million).
Analyze the situation from the shareholders' perspective. Which project are they financially incentivized to choose, and why? Explain how the potential outcomes differ for the shareholders versus the bank.
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Project B: A high-risk venture with a 30% chance of earning a $500,000 profit and a 70% chance of losing the entire $100,000 investment, plus incurring an additional $200,000 in debt that the business cannot pay.
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