1.Assume that the firm's market value of equity, S, is a call option written on the market value of the firm, V, with exercise price equal to the face value of the firm's risky debt, D. The debt is a 5-year zero-coupon bond and the firm has a policy of not paying cash dividends.

D = $1,000;

V = $2,000;

The risk-free rate R = 6%;

The standard deviation of V = 20%.

Using an options framework, determine the following:

a.the firm's market values of equity and debt; (8pt)

b.the risk premium to be charged on the loan; (7pt)

c.the probability that the firm will default on its debt. (7pt)

Answer rating: 100% (QA)

a To determine the firms market values of equity and debt using an options framework we can consider ... View the full answer