Question 1

1) Universal Auto Limited has a zero coupon bond outstanding with a S50,000 face value that matures in one year. The current market value of the firm's assets is S58,000. The standard deviation of the return on the firm's assets is 28 percent per year, and the risk-free rate is 5 percent per year, compounded continuously. What is the market value of the firm's equity and debt? Use four decimal points for the cumulative probability computations.

2) Suppose the government provides a guarantee for the firm's bond. What will be the market value of the firm's debt? What is the value of the government's guarantee?

3) Continuing with part 2) above, the government guarantee may be regarded as a put option.Who owns the put option? What is the exercise price of the put option? What should the shareholders and bondholders do if the asset value of the firm drops to S36.000 at the end of one year?

4 Using the idea of options, explain why shareholders in a levered firm have incentives to undertake high risk investments.