Question 1. Cost of Insuring the value of an asset
Please answer the following questions based on the attached calculation, and please make sure that you follow the note below before reading the questions: (I already did the calculation but prof’s notes)
– Each question/subquestion needs 1-2 paragraph to answer, no limits, as long as you prove the points and answer the question.
-To calculate value of equity: Remember: Equity = max (Asset – Debt, 0) So, treat equity like a call option, use B-S formula calculator to find call premium.
-Q2 is calculated equity value from BS (call premium) = $508.11. Then just found the debt value by $1bn – call premium = $491.89
-Q3 & Q4 are linked to Q2, so make sure three of those
have same volatility to get the answer.
Question 1. Cost of
Insuring the value of an asset
If the owner of XYZ stock would like to reduce their risk of holding the stock by insuring its current value of $100/share for the next 12 months. The owner can fully insure against loss (no deductible) or select coverage with a deductible, in which shareholder is responsible for the first losses on the stock up to limit. A 5% deductible means the shareholder takes the loss if the stock falls from $100 up to a maximum of $5 if the stock fell to $95; any further decline in the stock is covered by the insurance.
The dividend yield on XYZ =0.0%; its dividend yield is 0.0%; the annualized volatility [standard deviation] of XYZ returns = 50%. The risk-free interest = 1.0%. Using the calculator, determine the 1-year insurance premium for
a. 0% deductible
b. 5% deductible
c. 10% deductible
d. 20% deductible
Question 2. Impact of a change in asset volatility on the debt and equity of the firm
ABC is currently a consumer-staples business. Its capital structure has equity and single-issue zero-coupon debt with a total face value of $500 million payable in 5 years. No dividends can be paid on the equity until the debt is paid. The market value of ABC’s assets = $1.0 billion and the annualized volatility of the asset value = 20%. The risk-free interest = 0.0%
a. Compute the current values of the equity and debt of ABC. What is ABC’s debt-to-equity ratio using market values of its equity and debt.
Completely unknown to the market, ABC’s management is considering changing ABC’s business to become either a consumer electronics firm or a biotechnology firm. It would do so by acquiring assets in the selected new business at fair-market value and would pay for the assets either by selling it consumer-staples assets or exchanging them, at fair-market prices. So that the market value of XYZ assets would remain unchanged.
b. The annualized volatility of the consumer electronics assets = 30%. Compute the market value of the debt and equity of ABC if the transaction is the purchase of consumer electronics.
c. The annualized volatility of the biotechnology assets = 50%. Compute the market value of the debt and equity of ABC if the transaction is the purchase of consumer electronics. What is the market-value ABC debt-to-equity ratio, after the transaction?
d. The board of directors of ABC are elected by the shareholders and have a fiduciary responsibility to them. They do not have a fiduciary responsibility to ABC debtholders. Given your answers to a.-c., which new business is likely to be selected, and explain why?
Question 3. Impact of a change in asset volatility on multiple debt issues–junior and senior debt
ABC is currently a consumer-staples business. Its capital structure has equity, zero-coupon senior debt with a face value of $250 million payable in 5 years, and zero-coupon junior debt also with a face value of $250 million payable in 5 years. Junior debt is subordinated to senior debt and receives no payment until senior debt is fully paid its face value. No dividends can be paid on the equity until all the debt is paid. The market value of ABC’s assets = $1.0 billion and the annualized volatility of the asset value = 20%. The risk-free interest = 0.0%.
a. Compute the current values of the equity, senior and debt of ABC. What is ABC’s senior debt-to-junior-debt ratio using market values?
As in Question 2, completely unknown to the market, ABC’s management is considering changing ABC’s business to become either a consumer electronics firm or a biotechnology firm. It would do so by acquiring assets in the selected new business at fair-market value and would pay for the assets either by selling it consumer-staples assets or exchanging them, at fair-market prices. So that the market value of ABC assets would remain unchanged.
b. The annualized volatility of the consumer electronics assets = 30%. Compute the market value of the equity, senior and junior debt of ABC, if the transaction is the purchase of consumer electronics. What is ABC’s senior debt-to-junior-debt ratio using market values?
c. The annualized volatility of the biotechnology assets = 50%. Compute the market value of t equity, senior and junior debt of ABC if the transaction is the purchase of consumer electronics. What is the market-value ABC debt-to-equity ratio, after the transaction?
d. Comparing with your answers in Question 2, is the value of equity different when there is a single or multiple debt issues with the same total face value? Explain why?
Question 4. Impact of a change in asset volatility with different face value junior and senior debt issues
ABC is currently a consumer-staples business. Its capital structure has equity, zero-coupon senior debt with a face value of $400 million payable in 5 years, and zero-coupon junior debt also with a face value of $100 million payable in 5 years. Junior debt is subordinated to senior debt and receives no payment until senior debt is fully paid its face value. No dividends can be paid on the equity until all the debt is paid. The market value of ABC’s assets = $1.0 billion and the annualized volatility of the asset value = 20%. The risk-free interest = 0.0%.
a. Compute the current values of the equity, senior and debt of ABC. What is ABC’s senior debt-to-junior-debt ratio using market values?
As in Question 3, completely unknown to the market, ABC’s management is considering changing ABC’s business to become either a consumer electronics firm or a biotechnology firm. It would do so by acquiring assets in the selected new business at fair-market value and would pay for the assets either by selling it consumer-staples assets or exchanging them, at fair-market prices. So that the market value of ABC assets would remain unchanged.
b. The annualized volatility of the consumer electronics assets = 30%. Compute the market value of the equity, senior and junior debt of ABC, if the transaction is the purchase of consumer electronics. What is ABC’s senior debt-to-junior-debt ratio using market values?
c. The annualized volatility of the biotechnology assets = 50%. Compute the market value of t equity, senior and junior debt of ABC if the transaction is the purchase of consumer electronics. What is the market-value ABC debt-to-equity ratio, after the transaction?
d. Comparing with your answers in Question 3, what is the incremental impact on the senior debt value and hence risk sensitivity of asset volatility change, when the face-value size of senior debt is a larger proportion of total debt than face value of junior debt?
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