1. An insurance policy is considered analogous to an option. From a policyholder's perspective, what type of option is an insurance policy? Why?

Problem 22-24 Mergers and Equity as an Option

Sunburn Sunscreen has a zero coupon bond issue outstanding with a $29,000 face value that matures in one year. The current market value of the firms assets is $30,700. The standard deviation of the return on the firms assets is 37 percent per year, and the annual risk-free rate is 6 percent per year, compounded continuously.

Frostbite Thermalwear has a zero coupon bond issue outstanding with a face value of $33,000 that matures in one year. The current market value of the firms assets is $36,400. The standard deviation of the return on the firms assets is 43 percent per year.

Suppose Sunburn Sunscreen and Frostbite Thermalwear have decided to merge. Because the two companies have seasonal sales, the combined firms return on assets will have a standard deviation of 21 percent per year.

a-1.	What is the combined value of equity in the two existing companies? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Equity

$

a-2.	What is the combined value of debt in the two existing companies? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Debt

$

b-1.	What is the value of the new firms equity? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Equity

$

b-2.	What is the value of the new firms debt? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Debt

$

c-1.	What was the gain or loss for shareholders? (Loss amount should be indicated by a minus sign. Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Gain / Loss

$

c-2.	What was the gain or loss for bondholders? (Loss amount should be indicated by a minus sign. Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Gain / Loss

$