Watson Corp. has a zero coupon bond that matures in five years with a face value of $85,000. The current value of the company’s assets is $69,000, and the standard deviation of its return on assets is 50 percent per year. The risk-free rate is 6 percent per year, compounded continuously.

a. What is the value of a risk-free bond with the same face value and maturity as the current bond?

b. What is the value of a put option on the firm’s assets with a strike price equal to the face value of the debt?

c. Using the answers from (a) and (b), what is the value of the firm’s debt? What is the continuously compounded yield on the company’s debt?

d. Assume the company can restructure its assets so that the standard deviation of its return on assets increases to 60 percent per year. What happens to the value of the debt? What is the new continuously compounded yield on the debt? Reconcile your answers in (c) and (d).

e. What happens to bondholders if the company restructures its assets? What happens to shareholders? How does this create an agency problem?