Colosseum Corp. has a zero coupon bond that matures in five years with a face value of

Question:

Colosseum Corp. has a zero coupon bond that matures in five years with a face value of $65,000. The current value of the company’s assets is $62,000, and the standard deviation of its return on assets is 34 percent per year. The risk-free rate is 7 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 43 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?

Strike Price
In finance, the strike price of an option is the fixed price at which the owner of the option can buy, or sell, the underlying security or commodity. Coupon
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a... Face Value
Face value is a financial term used to describe the nominal or dollar value of a security, as stated by its issuer. For stocks, the face value is the original cost of the stock, as listed on the certificate. For bonds, it is the amount paid to the... Maturity
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. The term is commonly used for deposits, foreign exchange spot, and forward transactions, interest...

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