Problem 15-12 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 $2 million face value, zero coupon debt that is due in 2 years. The risk-free rate is 5%, 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.

a. Using the Black-Scholes option pricing model, how much is Fethe's equity worth? In your calculations round normal distribution values to 4 decimal places. Round your answer to two decimal places.

$__________ million ?

b.How much is the debt worth today? What is its yield? Round your answer for the debt worth to two decimal places. Round your answer for the yield on the debt to one decimal place.

Debt worth today: $ __________million Yield on the debt: _________%

c. 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 35%? In your calculations round normal distribution values to 4 decimal places. Round your answer for the equity worth to two decimal places. Round your answer for the yield on the debt 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 ____________ lessmoreItem 6 of a chance of a "home run".