Question

11. Equity as an option

Baker Corp. is a manufacturing firm. Baker Corp.’s current value of operations, including debt and equity, is estimated to be $10 million. Baker Corp. has $4 million face-value zero coupon debt that is due in two years. The risk-free rate is 6%, and the volatility of companies similar to Baker Corp. is 50%. Baker Corp.’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.)

Baker Corp. Value (Millions of dollars)
Equity value
Debt value
Debt yield

Baker Corp.’s management is implementing a risk management strategy to reduce its volatility. Complete the following table, assuming that the goal is to reduce Baker Corp.’s volatility to 30%.

Baker Corp. 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 Baker Corp.’s risk management strategy is successful:

If its risk management strategy is successful and Baker Corp. can reduce its volatility, the value of Baker Corp.’s debt will increase/decrease , and the value of its stock will increase/ decrease .

Answer 1

Answer-

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