Options and Corporate Finance (20 points)

Badco Inc. is a firm in distress. The current value of its assets is only $50 million but has a loan on its
books that requires it to pay $80 million one year from today.

a. (3 pts) Provide an explanation as to why Badco’s equity would have a positive market value today
given its current liquidation value is 0.

b. (6 pts) Suppose that the market believes that the volatility of Badco’s asset value to be captured by
the simple assumption that in one year’s time the firm’s assets will either be worth $25 million or $100
million. Using either the replicating portfolio or risk neutral probability method of binominal option
pricing, determine an estimate of the current value of the firm’s equity under these assumptions. The
current 1-yr risk free rate is 5% (APR).

c. (8 pts) If Badco’s debt was default free, it would have a market value today of $76.19 million
($80m/1.05). The actual value of Badco’s risky debt today is less than this because the equity holders
have the right to default (repay the loan by giving the debt holders the assets of the firm). This right is a
put option on the assets of the firm. Determine the value of this put option using the other option
pricing technique NOT used above AND demonstrate that the value of Badco’s risky debt today, D = V –

E from your information in part b, is equal (±$1m) to the value of the debt if risk free minus the value of
this put option..

d. (3 pts) What would happen to the wealth of the debt holders if the firm were to increase the riskiness
of its assets over the coming year? Explain how can debt holders protect themselves against actions of
this sort

2. (20 points) Options: Shares of Microsoft Inc are currently trading at $50. The US dollar risk free rate of
interest for 1 year is 0.65% (APR). The price of Microsoft shares is expected to have an annualized
volatility of 25%. a. (10 pts) Given this information, determine the value of a call option on Microsoft
stock that matures in exactly 1 year and has a strike price of $60 per share.

(4 pts) Determine the value of the companion 1 year put option on Microsoft stock with strike price of
$60 per share.

(6 pts) Now consider 6-month options on McCormick shares with a strike price of $90 per share.
Currently McCormick’s shares trade for $94.00 per share. The risk free rate for 6 months is 0.50% (APR).
Using put-call parity determine the impact of the following changes in conditions on the relative price of
the call versus the put (i.e. change in price of call – price of put).

i. Increase in strike price to $100 per share

ii. ii. An decrease in the expected idiosyncratic volatility of McCormick over the next six months
iii. iii. An increase in the maturity of the options to 12 months (1-year
. Options (25 points). The equity and debt of a firm can be thought of and priced using the framework of
option theory. Consider a levered firm that has zero coupon debt with face value D that matures in 6
months.

a. (4 pts) Explain the how the equity of this levered firm can be thought of as a six month call option.
Who owns this option and what is it an option on?

b. (4 pts) Explain how this risky corporate debt with face value D that matures in six months can be
thought of as a portfolio of a 6 month risk-free (zero coupon) bond of face value D and short (sold)
position in a 6 month put option on the firm’s assets. Who owns this option and what is it an option on?

c. (6 pts) Using option theory, conceptually explain how an increase in the following variables would
change the current value of the equity of a distressed firm (one where currently D > V but debt is not yet
due) assuming the increase in the variable had no impact on the current value of the firm’s assets. i. the
variance of the firm’s future asset value ii. the risk free interest rate iii. the maturity of the debt SAIS
380.760 Corporate Finance Final Exam Spring 2015 p. 4

d. (5 pts) Suppose the firm’s current situation is the following: Current market value of firm’s assets =
$50M Face value of existing debt = $60M Time remaining until debt maturity = 0.5 year (6 months) 6
month risk free interest rate = 0.50% (APR) Future market value of firm’s assets in 6 months: either falls
to $30M or rises to $80M Using this information determine the current market value of the firm’s equity
assuming it is priced as a call option. You may use your choice of option pricing methods.

e. (3 pts) What is the current value of the put option to default on the debt?

f. (3 pts) Assuming the firm’s debt is zero coupon, determine the current (annualized) risk premium on
the firm’s debt (i.e., the difference between the risky debt’s yield to maturity (APR) and the 6 month
treasury rate (APR)).