Q3

Recall from your previous corporate finance studies. For a levered firm, firm's assets are financed by equity and debt. That is, = + , where , & represents asset value, debt value and equity value at time . Suppose the firm makes no dividend payment and has a zero-coupon debt maturing at time . At maturity, if the value of the company asset is greater than the maturity value of the debt ( > ), the company will simply pay off the debt. Otherwise, the company will declare bankruptcy and debt holders will own the firm.

PART A

At maturity = :

(i) From an equity holder perspective, describe a company's equity as a call option. In your answers, identify the underlying asset, strike price, maturity, and the payoff function of the call option.

(ii) From a debt holder perspective, describe a company's debt using a call option. In your answers, identify the positions that the debt holder takes on each asset (i.e. long or short?).

At time = 0:

(iii) Suppose and are option prices (i.e. premium) for call and put options. Using the result from part (i) and put-call parity, describe a company's debt using a put option from a debt holder perspective. In your answers, identify the positions that the debt holder takes on each asset (i.e. long or short?).

PART B

(iv) Energy Dynamic is a company with 10 million shares outstanding. The current asset value is $90m and it has a zero-coupon corporate debt of $100m face value due in 5 years. Suppose company's asset volatility is 25% and the risk-free interest rate is 6% per annum with continuous compounding. The company makes no dividend payment. Apply the Black Scholes model to estimate company's equity value. What is the share price?

(v) Given your answers in part (iv), what is the yield to maturity on the debt?