| Equity Viewed as an Option
A. Fethe Inc. is a custom manufacturer of guitars, mandolins, and other stringed instruments and is located near Knoxville, Tennessee. Fethe’s current value of operations, which is also its value of debt plus equity, is estimated to be $5 million. Fethe has $2 million face value, zero coupon debt that is due in 2 years. The risk-free rate is 6%, and the standard deviation of returns for companies similar to Fethe is 50%. Fethe’s owners view their equity investment as an option and they would like to know the value of their investment. a. Using the Black-Scholes option pricing model, how much is Fethe’s equity worth? b. How much is the debt worth today? What is its yield? c. How would the equity value and the yield on the debt change if Fethe’s managers could use risk management techniques to reduce its volatility to 30%? Can you explain this? |
Chapter 15: Capital Structure Decisions Problems
Book Title: Financial Management: Theory and Practice
Printed By: Kristina Mack ([email protected]) © 2017 Cengage Learning, Cengage Learning
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