Equity as an Option ABC has a zero-coupon bond issue outstanding with a

$10,000 face value that matures in one year. The current market value of the

firms assets is $11,200. The standard deviation of the return on the firms assets

is 38 percent per year and the annual risk-free rate is 5 percent per year,

compounded continuously.

a) Based on the Black-Scholes model, what is the market value of the

firms equity and debt?

Suppose ABC is considering two mutually exclusive investments. Project A has

an NPV of $1,200 and Project B has an NPV of $1,600. As a result of taking

Project A, the standard deviation of the return on the firms assets will increase

to 55 percent per year. If Project B is taken, the standard deviation will fall to 34

percent per year.

b) What is the value of the firms equity and debt if Project A is

undertaken? If Project B is undertaken?

c) Which project would the stockholders prefer?