Question: What if Ls debt is risky? For the purpose of this example, assume that the value of Ls operations is $4 millionwhich is the value

What if L’s debt is risky? For the purpose of this example, assume that the value of L’s operations is $4 million—which is the value of its debt plus equity. Assume also that its debt consists of 1-year zero coupon bonds with a face value of $2 million. Finally, assume that L’s volatility is 0.60 (( = 0.60) and that the risk free rate is 6 percent.

MINI CASE

David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30 percent debt, and Mr. Lyons wonders why they use so much more debt, and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:

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Ls equity can be considered as a call option on the total value of l with an exercise price of 2 mil... View full answer

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