13. Equity as an option

Consider the case of Fat Mouse Dairy Products:

Fat Mouse Dairy Products is a manufacturing firm. Fat Mouses current value of operations, including debt and equity, is estimated to be $5 million. Fat Mouse has $2 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 Fat Mouse is 50%. Fat Mouses 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. Do not round intermediate calculations. Round final answers to two decimal places.)

Values: Fat Mouse Dairy Products
Equity value
Debt value
Debt yield

Fat Mouses management is implementing a risk management strategy to reduce its volatility. Complete the following table, assuming that the goal is to reduce the companys volatility to 30%. (Note: Do not round intermediate calculations. Round final answers to two decimal places.)

Goals: Fat Mouse Dairy Products
Equity value at 30% volatility
Debt value at 30% volatility
Debt yield at 30% volatility

Complete the following sentence, assuming that Fat Mouses risk management strategy is successful:

If its risk management strategy is successful and Fat Mouse can reduce its volatility, the value of Fat Mouses debt will , and the value of its stock will .