Question

Equity as an option Tucci Co. is a manufacturing firm. Tucci Co.’s current value of operations, including debt and equity, is estimated to be $25 million. Tucci Co. has $10 million face-value zero coupon debt that is due in two years. The risk-free rate is 5%, and the volatility of companies similar to Tucci Co. is 50%. Tucci Co.’s performance has not been very good as compared to previous years. Because the company has debt, it will repay its loan, but the company has the option of not paying equity holders. The ability to make the decision of whether to pay or not looks very much like an option. Based on your understanding of the Black-Scholes option pricing model (OPM), calculate the following values and complete the table. (Note: Use 2.7183 as the approximate value of e in your calculations. Also, do not round intermediate calculations. Round your answers to two decimal places.) Tucci Co. Value (Millions of dollars) Equity value Debt value Debt yield Tucci Co.’s management is implementing a risk management strategy to reduce its volatility. Complete the following table, assuming that the goal is to reduce Tucci Co.’s volatility to 30%. Tucci Co. Goal (Millions of dollars) Equity value at 30% volatility Debt value at 30% volatility Debt yield at 30% volatility Complete the following sentence, assuming that Tucci Co.’s risk management strategy is successful: If its risk management strategy is successful and Tucci Co. can reduce its volatility, the value of Tucci Co.’s stock will , and the value of its debt will .

Answer 1

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