Equity as an option

Strong Co$.$ is a manufacturing firm. Strong Co$.\text{'}$s current value of operations, including debt and equity, is estimated to be $$35$ million. Strong Co$.$ has

$$14$ million face$-$value zero coupon debt that is due in two years. The risk$-$free rate is $5\%,$ and the volatility of companies similar to Strong Co$.$ is $60\%.$

Strong Co$.\text{'}$s 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

$2\mathrm{.}7183$ as the approximate value of e in your calculations. Also, do not round intermediate calculations. Round your answers to two decimal places.$)$

Strong Co$.$ Value $($Millions of dollars$)$

Equity value

Debt value

Debt yield

Strong Co$.\text{'}$s management is implementing a risk management strategy to reduce its volatility. Complete the following table, assuming that the goal is

to reduce Strong Co$.\text{'}$s volatility to $30\%.$

Strong Co$.$ Goal $($Millions of dollars$)$

Equity value at $30\%$ volatility

Debt value at $30\%$ volatility

Debt yield at $30\%$ volatility

Complete the following sentence, assuming that Strong Co$.\text{'}$s risk management strategy is successful:

If its risk management strategy is successful and Strong Co$.$ can reduce its volatility, the value of Strong Co$.\text{'}$s stock will

of its debt will