Question
Suppose that rather than being entirely equity financed, the firm had a large bond outstanding with a face value of $10 million and a coupon
Suppose that rather than being entirely equity financed, the firm had a large bond outstanding with a face value of $10 million and a coupon of 5%, which is due in its entirety next year (so the firm will have to effectively pay off a $10,500,000 loan next year). Suppose that the annual risk- free interest rate is 5% and that the standard deviation of the firms asset value is 25%. Begin to calculate the value of the firms debt using the Black Scholes option formula. Calculate the d1 and d2 in that formula. Use the normal distribution CDF attached to find the N(d1) and N(d2) values. Calculate the value of the option component of the firms debt using the Black Scholes formula. What is the value of the companys debt? Explain why it is appropriate to think of corporate debt as equivalent to a portfolio where we own the companys assets while writing (selling) a call option on the firms assets for a strike price equal to the total payment amount (principal and interest) of the firms debt
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