Chapter 16 Problem 12

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 $3 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.

1. Using the Black-Scholes option pricing model, how much is Fethe's equity worth? Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to two decimal places. $ million

2. How much is the debt worth today? What is its yield? Enter your answer for debt worth in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round the monetary value to two decimal places and percentage value to one decimal place. Debt worth today: $ million Yield on the debt: %

3. 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%? Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round the monetary value to two decimal places and percentage value to one decimal place. New equity worth: $ million New yield on the debt: % Can you explain this? The value of the stock goes down and the value of the debt goes up because with lower risk, Fethe has -Select-lessmoreItem 6 of a chance of a "home run".