61. Two-State Option Pricing and Corporate Valuation

Strudler Real Estate Ltd., a construction firm financed by both debt and equity, is undertaking a new project. If the project is successful, the value of the firm in one year will be $410 million, but if the project is a failure, the firm will be worth only $255 million. The current value of Strudler is $295 million, a figure that includes the prospects for the new project. Strudler has outstanding zero-coupon bonds due in one year with a face value of $325 million. Treasury bills that mature in one year yield a 6 percent EAR. Strudler pays no dividends.

Suppose that in place of the preceding project, Strudlers management decides to undertake a project that is even more risky. The value of the firm will either increase to $445 million or decrease to $240 million by the end of the year. Surprisingly, management concludes that the value of the firm today will remain at exactly $295 million if this risky project is substituted for the less risky one.

a) Use the two-state option pricing model to determine the values of the firms debt if the firm plans on undertaking this new project.

b) Which project do bondholders prefer?

1. Riskier Project

2. Conservative Project