Parts a and b are not directly related. Company X has only debt and equity in it
ID: 2730419 • Letter: P
Question
Parts a and b are not directly related. Company X has only debt and equity in its capital structure. The total market value of the firm's assets is $25 million. The total market value of debt is $10 million. The total market value of equity is $15 million. All of the debt matures in 15 years, and has a face value of $20 million. After the current debt matures, the company intends to issue new debt with a 10 year maturity. Is the equity value in this company equivalent to a call option or is it equivalent to a put option? What is the strike price of the option? What is the time to expiry of the option? The current price of an asset is $1.5 million. Next year it may be worth $2 million, if the economy does well, or it may be worth only $1 million, if the economy does badly. The risk-free rate is 8%. Calculate the price of a one-year call option on this asset, with an strike price of $1.2 million.Explanation / Answer
Answer of question 1:
Equity payoff is identical to the payoff on a call option written on the assets (value) of the firm with a strike price equal to the face value of the debt and maturity equal to the maturity of the debt.