Question
You are the sole bondholder in a firm that will be liquidated next year. Your main concern is that you will not be paid back
You are the sole bondholder in a firm that will be liquidated next year. Your main concern is that you will not be paid back the $200M you are owed at that time. The current market value of the firm is $225M, although it is unknown what the market value will be next year. a)Provide the payoff diagram for the bondholder with the final market value of the firm on the x-axis. b)The financial manager of the firm is currently considering a project that will cause the market value of the firm to be equal to either $450M or nothing next year with equal probability.Assume that the bondholders and shareholders have to maintain their positions until firm liquidation next year. What is the expected payoff to bondholders and shareholders next year under this project? (Hint:Use the table below.)
Firm value next year | Bondholder payoff | Stockholder payoff |
$450M | ||
$0M | ||
Expected payoff next year |
c)If you were to completely protect yourself against the state of the world where the firm does not pay you back, would you buy a (call or put)option on the final market value of the assets of the firm, and at what strike price? d)This option youpurchase has a price of only $40M. You decide to borrow the $40M, in order to pay for the option, at a 10% interest rate. The loan plus interest must be repaid in one year. What is your total expected payoff (bond + option loan repayment) in one year?(Hint:Use the table below.)
Firm value next year | Payoff from bond | Payoff from option | loan repayment | Total payoff |
$450M | ||||
$0M | ||||
Expected payoff next year |
Firms that go bankrupt are typically unable to fully repay all bondholders. Bondholders can protect themselves from this by entering into Credit Default Swaps, in which they pay a third counterparty a fee (or a sequence of fees over time), and in exchange the third counterparty will repay the bondholders instead in the event that the firm goes bankrupt (you also hand over the bond to that third counterparty). Credit Default Swaps are, in essence, the option that you purchased in part (c).
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