Your firm has a market value balance sheet of Assets ($20) = Debt (14.3) + Equit

Question

Your firm has a market value balance sheet of Assets ($20) = Debt (14.3) + Equity ($5.7), which we can call a Base Case. Other information is the face value of debt is $40, the debt matures in 5 years, the Asset return standard deviation = 50%, and the risk free rate is 4%. You have three mutually exclusive capital budgeting projects from which to choose. Project A has an NPV of $4. Project A’s Standard Deviation is 40%. If Project A is accepted, the firm’s new Asset Value will be $24 and the new Debt Value will be 18.0. Project B has an NPV of $1. Project B’s Standard Deviation is 60%. If Project B is accepted, the firm’s new Asset Value will be $21 and the new Debt Value will be 13.2. Project C has an NPV of -$1. Project C’s Standard Deviation is 80%. If Project C is accepted, the firm’s new Asset Value will be $19 and the new Debt Value will be 12.7. a. (3 points) What is the value of the put option associated with the risky debt in Scenario B? b. (4 points) Considering accepting mutually exclusive Projects A, B, C, or rejecting all three projects, what is the optimal strategy? Why?

Explanation / Answer

a) The value of put option shall be derived from debt value. If standard deviation is 60% and debt value is 13.2 then the value of put option will be 13.2

b) Considering all three mutually exclusive projects, only project A is worth selection. It has the highest NPV and lowest standard deviation. It will also bring more dependence on debt capital with a debt value of $18 out of total asset value of $24 but the level of associated risk is within company's accepted risk level of 40%. Hence the optimal strategy is to choose A.

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.