Start with the partial model in the file FM12 Ch 17 P11 Build a Model.xls at the textbook’s Web site. Rework Problem 17-10 using a spreadsheet model. After completing the problem as it appears, answer the following related questions.
a. Graph the cost of debt versus the face value of debt for values of the face value from $0.5 to $8 million.
b. Graph the values of debt and equity for volatilities from 0.10 to 0.90 when the face value of the debt is $2 million.
c. Repeat part b, but instead using a face value of debt of $5 million. What can you say about the difference between the graphs in part b and part c?
Given Data
A. Fethe is a custom manufacturer of guitars, mandolins and other stringed instruments located near Knoxville, TN. Fethe's current value of operations, which is also its value of debt plus equity, is estimated to be $5 million. Fethe has $2 million face-value zero-coupon debt that is due in 2 years. The risk free rate is 6 percent, and the volatility of companies similar to Fethe is 50 percent. Fethe's owners view their equity investment as an option and would like to know the value of their investment.
a. Using the Black-Scholes Option Pricing Model, how much is Fethe's equity worth?
b. How much is the debt worth today? What is its yield?
c. How much would the equity value and the yield on the debt change if Fethe's management were able to use risk management techniques to reduce its volatility to 30 percent? Can you explain this?
a. Graph the cost of debt versus the face value of debt for values of the face value from $0.5 to $8 million.
b. Graph the values of debt and equity for volatilities from 0.10 to 0.90 when the face value of the debt is $2 million.
c. Repeat part b, but instead using a face value of debt of $5 million. What can you say about the difference between the graphs in part b and part c?
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