Consider two firms that differ with respect to asset risk and financial leverage. Firm 1 owns assets worth $10,000,000 and has issued zero-coupon bonds with a face value of $4,500,000. On the other hand, Firm 2 owns assets worth $25,000,000 and has issued zero-coupon bonds with a face value of $15,000,000. The standard deviation of the return on firm 1’s assets is 40%, whereas the standard deviation of the return on firm 2’s assets is 50%. Assume that both firms will be liquidated one year from today and that the rate of interest is 3%.

1. What is the fair market value for the bonds issued by Firm 1? What is the dollar value of Firm 1’s limited liability put option? What is the yield to maturity, credit risk premium, and (risk-neutral) probability of default for Firm 1’s bonds?

2. What is the fair market value for the bonds issued by Firm 2? What is the dollar value of Firm 2’s limited liability put option? What is the yield to maturity, credit risk premium, and (risk-neutral) probability of default for Firm 2’s bonds?

3. Suppose an insurer offers the shareholders of both firms a credit enhancement scheme that will make their bonds riskless. What are the fair premiums for this insurance? What impact will this insurance have upon the yields to maturity of these bonds?

Answer rating: 100% (QA)

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