Question

Buffalo Flats Inc. has 10 million shares trading at $25 per share. It also has zero coupon debt outstanding. The debt is due in one year. It was originally issued to pay 8% compounded annually. The debt has a par (face) value of $350 million, but the current market value is $280 million. The risk-free rate is 6% compounded annually. a. Calculate the value of limited liability for Buffalo's shareholders. Hint: translate put-call parity into the appropriate components for a levered firm. b. From an option pricing perspective, explain the shareholders' financial position.

Answer 1

Answer :

a. Calculation the value of limited liability for Buffalo's shareholders.

By using put-call parity into the appropriate components for a levered firm.

In Put Call Parity the premium is calculated by using following formulae

C + ( PV ( A ) ) = P + S

Here,

C = Call Option Price

PV ( A ) = Present value of Maturity period at risk free rate of return

P = Put Option Price

S = Strike Price

Here P-C ( i.e. Put price - Call price ) is Premium of the option .

In the given problem if we use the above concept then Limited Liability for Buffalo's Shareholders is ( P-C) . As in given case Limited Liability is the price which is liable to pay by shareholders , which is calculated by deduction Current Market Price from the discounted price of Option at maturity.

C + ( $ 350 Million / 1.06) = P + $ 280 Million

P-C = $ 330.1887 Million - $ 280 Million = $ 50.1887 Million

b. From an option pricing perspective, explain the shareholders' financial position:

Market Cap of Buffelo's Shares = $ 25 Per Share x 10 Million Shares = $ 250 Million

Limited Liability of Buffelo's Shareholders ( As per Above Calculation ) = $ 50.1887 Million

Shareholder's Position is declined in the Market Cap upto the Limited Liability Amount = $ 250 Million - $ 50.1887 Million = $ 199.8113

Market Value of Buffelo's Share declined from $ 25 Per Share to $ 19.98 Per Share ( $ 199.8113 / 10 Million Shares )