Company X has only debt and equity in its capital structure. The total market va

Question

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

A)1The equity  value  of the company  equivalent to the call option granted by creditors to shareholders on the company's operating assets.  

2)The strike price is the face value of the debt which is 20 million $

3) The maturity is the date on which the debt is payable ie 15 years

B ) Using the Black-Scholes formula to compute the value of given call option the value is

Current stock price is 150million $

T=365 days

K = 1230 million $

R =8%

Volatility=.50

=9,640,926.6466

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