Financial Management: Theory & Practice
16th Edition
ISBN: 9781337909730
Author: Brigham
Publisher: Cengage
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Chapter 15, Problem 10MC
Liu Industries is a highly levered firm. Suppose there is a large probability that Liu will default on its debt. The value of Liu’s operations is $4 million. The firm’s debt consists of 1-year, zero coupon bonds with a face value of $2 million. Liu’s volatility, σ, is 0.60, and the risk-free rate rRF is 6%.
Because Liu’s debt is risky, its equity is like a call option and can be valued with the Black-Scholes Option Pricing Model (OPM). (See Chapter 8 for details of the OPM.)
- (1) What are the values of Liu’s stock and debt? What is the yield on the debt?
- (2) What are the values of Liu’s stock and debt for volatilities of 0.40 and 0.80? What are yields on the debt?
- (3) What incentives might the manager of Liu have if she understands the relationship between equity value and volatility? What might debtholders do in response?
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Chapter 15 Solutions
Financial Management: Theory & Practice
Ch. 15 - Prob. 1QCh. 15 - What term refers to the uncertainty inherent in...Ch. 15 - Firms with relatively high nonfinancial fixed...Ch. 15 - “One type of leverage affects both EBIT and EPS....Ch. 15 - Why is the following statement true? Other things...Ch. 15 - Why do public utility companies usually have...Ch. 15 - Why is EBIT generally considered to be independent...Ch. 15 - If a firm went from zero debt to successively...Ch. 15 - Prob. 9QCh. 15 - Prob. 1P
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