Chapter 22

6. a. Using put-call parity and solving for the put price, we get:
S + P = Ee–Rt + C
$73 + P = $70e–.026(3/12) + $5.27
P = $1.82

b. Using put-call parity and solving for the call price we get:
S + P = Ee-Rt + C
$43 + 4.84 = $45e–.035(6/12) + C
C = $3.62

c. Using put-call parity and solving for the stock price we get:
S + P = Ee-Rt + C
S + $5.27 = $65e–.031(3/12) + $1.04
S = $60.27

d. Using put-call parity, we can solve for the risk-free rate as follows:
S + P = Ee–Rt + C
$52.27 + 5.99 = $50e–R(4/12) + $8.64
$49.62 = $50e–R(4/12)
.9924 = e–R(4/12)
ln(.9924) = ln(e–R(4/12))
–.0076 = –R(4/12)
R = .0229, or 2.29%

12. The delta of a call option is N(d1), so:

d1 = [ln($74/$70) + (.043 + .462/2)  (9/12)]/(.46  (9 / 12) ) = .4196

N(d1) = .6626

For a call option, the delta is .6626. For a put option, the delta is:

Put delta = .6626 – 1 = –.3374

The delta tells us the change in the price of an option for a $1 change in the price
of the underlying asset.
13. Using the Black-Scholes option pricing model, with a ‘stock’ price of $1,350,000 and an
exercise price of $1,600,000, the price you should receive is:

d1 = [ln($1,350,000/$1,600,000) + (.05 + .352/2)  (12/12)]/(.35  12 / 12 ) = –.1676

d2 = –.1676 – (.35  12 / 12 ) = –.5176

N(d1) = .4335

N(d2) = .3024

Putting these values into the Black-Scholes model, we find the call price is:

C = $1,350,000(.4335) – ($1,600,000e–.05(1))(.3024) = $124,960.94

24. a. The combined value of equity and debt of the two firms is:

Equity = $2,127.73 + 5,729.86

Equity = $7,857.60

Debt = $8,772.27 + 17,370.14

Debt = $26,142.40

b. For the new firm, the combined market value of assets is $34,000, and the
combined face value of debt is $30,000. Using Black-Scholes to find the value
of equity for the new firm, we find:

d1 = [ln($34,000/$30,000) + (.06 + .212/2)  1]/(.21  1 ) = .9867

d2 = .9867 – (.21  1 ) = .7767
N(d1) = .8381
N(d2) = .7813

Putting these values into the Black-Scholes model, we find the equity value is:
Equity = C = $34,000(.8381) – ($30,000e–.06(1))(.7813)
Equity = $6,420.65
The value of the debt is the firm value minus the value of the equity, so:
Debt = $34,000 – 6,420.65
Debt = $27,579.35
 c. The change in the value of the firm’s equity is:

Equity value change = $6,420.65 – 7,857.60

Equity value change = –$1,436.95

The change in the value of the firm’s debt is:

Debt value change = $27,579.35 – 26,142.40

Debt value change = $1,436.95

d. In a purely financial merger, when the standard deviation of the assets

declines, the value of the
equity declines as well. The shareholders will lose exactly the amount the
bondholders gain. The bondholders gain as a result of the coinsurance effect.
That is, it is less likely that the new company will default on the debt.

25. a. Using the Black-Scholes model to value the equity, we get:

d1 = [ln($15,100,000/$16,500,000) + (.06 + .412/2)  5]/(.41  5 ) = .6889

d2 = .6889 – (.41  5 ) = –.2279

N(d1) = .7546

N(d2) = .4099

Putting these values into Black-Scholes:

Equity = C = $15,100,000(.7546) – ($16,500,000e–.06(5))(.4099)

Equity = $6,383,803.25

b. The value of the debt is the firm value minus the value of the equity, so:

Debt = $15,100,000 – 6,383,803.25

Debt = $8,716,196.75

c. Using the equation for the PV of a continuously compounded lump sum, we get:
 $8,716,196.75 = $16,500,000e–R(5)
.5283 = e–R(5)
RD = –(1/5)ln(.5283)
RD = .1276, or 12.76%

d. Using the Black-Scholes model to value the equity, we get:

d1 = [ln($17,300,000/$16,500,000) + (.06 + .412/2)  5]/(.41  5 ) = .8373

d2 = .8373 – (.41  5 ) = –.0795

N(d1) = .7988

N(d2) = .4683

Putting these values into Black-Scholes:

Equity = C = $17,300,000(.7988) – ($16,500,000e–.06(5))(.4683)

Equity = $8,094,494.95

e. The value of the debt is the firm value minus the value of the equity, so:

Debt = $17,300,000 – 8,094,494.95

Debt = $9,205,505.05

Using the equation for the PV of a continuously compounded lump sum, we get:

$9,205,505.05 = $16,500,000e–R(5)
.5579 = e–R5
RD = –(1/5)ln(.5579)
RD = .1167, or 11.67%

When the firm accepts the new project, part of the NPV accrues to bondholders. This
increases the present value of the bond, thus reducing the return on the bond.
Additionally, the new project makes the firm safer in the sense it increases the value of
assets, thus increasing the probability the call will end in the money and the
bondholders will receive their payment.
28. a. The company would be interested in purchasing a call option on the price of
gold with a strike price of $1,940 per ounce and 3 months until expiration.
This option will compensate the company for any increases in the price of
gold above the strike price and places a cap on the amount the firm must pay
for gold at $1,940 per ounce.

b. In order to solve a problem using the two-state option model, first draw a
price tree containing both the current price of the underlying asset and the
underlying asset’s possible values at the time of the option’s expiration. Next,
draw a similar tree for the option, designating what its value will be at
expiration given either of the two possible stock price movements.

Price of gold Call option price with a strike of $1,940

Today 3 months Today 3 months

$2,035 $95 =Max($2,035 – 1,940,

0)

$1,820 ?

$1,670 $0 =Max($1,670 – 1,940,

0)

The price of gold is $1,820 per ounce today. If the price rises to $2,035, the
company will exercise its call option for $1,940 and receive a payoff of $95 at
expiration. If the price of gold falls to $1,670, the company will not exercise
its call option, and the firm will receive no payoff at expiration. If the price of
gold rises, its return over the period is 11.81 percent (= $2,035/$1,820 – 1).
If the price of gold falls, its return over the period is –8.24 percent (=
$1,670/$1,820 – 1). Use the following expression to determine the risk-
neutral probability of a rise in the price of gold:

Risk-free rate = (ProbabilityRise)(ReturnRise) + (ProbabilityFall)(ReturnFall)

Risk-free rate = (ProbabilityRise)(ReturnRise) + (1 – ProbabilityRise)(ReturnFall)

The risk-free rate over the next three months must be used in order to match
 the timing of the expected price change. Since the risk-free rate per annum
is 6.50 percent, the risk-free rate over the next three months is 1.59 percent
(= 1.06501/4 – 1), so:

.0159 = (ProbabilityRise)(.1181) + (1 – ProbabilityRise)(–.0824)

ProbabilityRise = .4901, or 49.01%

And the risk-neutral probability of a price decline is:

ProbabilityFall = 1 – ProbabilityRise
ProbabilityFall = 1 – .4901
ProbabilityFall = .5099, or 50.99%

Using these risk-neutral probabilities, we can determine the expected payoff

of the call option at expiration, which will be.

Expected payoff at expiration = (.4901)($95) + (.5099)($0)

Expected payoff at expiration = $46.56

Since this payoff occurs 3 months from now, it must be discounted at the risk-
free rate in order to find its present value. Doing so, we find:

PV(Expected payoff at expiration) = $46.56/1.06501/4

PV(Expected payoff at expiration) = $45.83

Therefore, given the information about gold’s price movements over the next
three months, a European call option with a strike price of $1,940 and three
months until expiration is worth $45.83 today.

c. Yes, there is a way to create a synthetic call option with identical payoffs to
the call option described above. In order to do this, the company will need
to buy gold and borrow at the risk-free rate. The amount of gold to buy is
based on the delta of the option, where delta is defined as:

Delta = (Swing of option)/(Swing of price of gold)

Since the call option will be worth $95 if the price of gold rises and $0 if it
falls, the swing of the call option is $95 (= $95 – 0). Since the price of gold will
 either be $2,035 or $1,670 at the time of the option’s expiration, the swing
of the price of gold is $365 (= $2,035 – 1,670). Given this information, the
delta of the call option is:

Delta = (Swing of option)/(Swing of price of gold)

Delta = $95/$365
Delta = .26

Therefore, the first step in creating a synthetic call option is to buy .26 of an
ounce of gold. Since gold currently sells for $1,820 per ounce, the company
will pay $473.70 (= .26 × $1,820) to purchase .26 of an ounce of gold. In order
to determine the amount that should be borrowed, compare the payoff of
the actual call option to the payoff of delta shares at expiration:

Call Option
If the price of gold rises to $2,035:
If the price of gold falls to $1,670:
Delta Shares
If the price of gold rises to $2,035:
If the price of gold falls to $1,670:
Payoff = $95
Payoff = $0
Payoff = (.26)($2,035) = $529.66
Payoff = (.26)($1,670) = $434.66

The payoff of this synthetic call position should be identical to the payoff of
an actual call option. However, buying .26 of a share leaves us exactly $434.66
above the payoff at expiration, whether the price of gold rises or falls. In
order to decrease the company’s payoff at expiration by $434.66, it should
borrow the present value of $434.66 now. In three months, the company
must pay $434.66, which will decrease its payoffs so that they exactly match
those of an actual call option. So, the amount to borrow today is:

Amount to borrow today = $434.66/1.06501/4

Amount to borrow today = $427.87

d. Since the company pays $473.70 in order to purchase gold and borrows
$427.87, the total cost of the synthetic call option is $45.83 (= $473.70 –
427.87). This is exactly the same price for an actual call option. Since an
actual call option and a synthetic call option provide identical payoff
structures, the company should not expect to pay more for one than for the
other.
31. a. Using the equation for the PV of a continuously compounded lump sum, we get:
PV = $75,000  e–.07(5)
PV = $52,851.61

b. Using the Black-Scholes model to value the equity, we get:

d1 = [ln($71,000/$75,000) + (.07 + .342/2)  5]/(.34  5 ) = .7684
d2 = .7684 – (.34  5 ) = .0081
N(d1) = .7789
N(d2) = .5032

Putting these values into Black-Scholes:

Equity = C = $71,000(.7789) – ($75,000e–.07(5))(.5032)
Equity = $28,702.77

And using put-call parity, the price of the put option is:
P = $75,000e–.07(5) + 28,702.77 – 71,000
P = $10,554.38

c. The value of a risky bond is the value of a risk-free bond minus the value of a put option
on the firm’s equity, so:
Value of risky bond = $52,851.61 – 10,554.38
Value of risky bond = $42,297.23

Using the equation for the PV of a continuously compounded lump sum to find the
return on debt, we get:
$42,297.23 = $75,000e–R(5)
.5640 = e–R(5)
RD = –(1/5)ln(.5640)
RD = .1146, or 11.46%

d. Using the equation for the PV of a continuously compounded lump sum, we get:
PV = $75,000  e–.07(5)
PV = $52,851.61
Using the Black-Scholes model to value the equity, we get:
d1 = [ln($71,000/$75,000) + (.07 + .432/2)  5]/(.43  5 ) = .7878
d2 = .7878 – (.43  5 ) = –.1737
N(d1) = .7846
N(d2) = .4310
 Putting these values into Black-Scholes:
Equity = C = $71,000(.7846) – ($75,000e–.07(5))(.4310)
Equity = $32,924.59

And using put-call parity, the price of the put option is:
P = $75,000e–.07(5) + 32,924.59 – 71,000
P = $14,776.19

The value of a risky bond is the value of a risk-free bond minus the value of a put option
on the firm’s equity, so:

Value of risky bond = $52,851.61 – 14,776.19

Value of risky bond = $38,075.41

Using the equation for the PV of a continuously compounded lump sum to find the
return on debt, we get:
$38,075.41 = $75,000e–R(5)
.5077 = e–R(5)
RD = –(1/5)ln(.5077)
RD = .1356, or 13.56%

The value of the debt declines. Since the standard deviation of the company’s assets
increases, the value of the put option on the face value of the bond increases, which
decreases the bond’s current value.

e. From c and d, bondholders lose: $38,075.41 – 42,297.23 = –$4,221.81

From c and d, stockholders gain: $32,924.59 – 28,702.77 = $4,221.81

This is an agency problem for bondholders. Management, acting to increase

shareholder wealth in this manner, will reduce bondholder wealth by the exact amount
that shareholder wealth is increased.
32. a. Since the equityholders of a firm financed partially with debt can be thought
of as holding a call option on the assets of the firm with a strike price equal
to the debt’s face value and a time to expiration equal to the debt’s time to
maturity, the value of the company’s equity equals a call option with a strike
price of $150 million and 1 year until expiration.

In order to value this option using the two-state option model, first draw a
tree containing both the current value of the firm and the firm’s possible
values at the time of the option’s expiration. Next, draw a similar tree for the
option, designating what its value will be at expiration given either of the two
possible changes in the firm’s value.

The value of the company today is $163 million. It will either increase to $198
million or decrease to $120 million in one year as a result of its new project.
If the firm’s value increases to $198 million, the equityholders will exercise
their call option, and they will receive a payoff of $48 million at expiration.
However, if the firm’s value decreases to $120 million, the equityholders will
not exercise their call option, and they will receive no payoff at expiration.

Equityholders’ call option price with a strike of $150

Value of company (in millions) (in millions)

Today 1 year Today 1 year

$198 $48 =Max($198 – 150, 0)

$163 ?

$120 $0 =Max($120 – 150, 0)

If the project is successful and the company’s value rises, the percentage
increase in value over the period is 21.47 percent (= $198/$163 – 1). If the
project is unsuccessful and the company’s value falls, the percentage
decrease in value over the period is –26.38 percent (= $120/$163 – 1). We
can determine the risk-neutral probability of an increase in the value of the
company as:
 Risk-free rate = (ProbabilityRise)(ReturnRise) + (ProbabilityFall)(ReturnFall)
Risk-free rate = (ProbabilityRise)(ReturnRise) + (1 – ProbabilityRise)(ReturnFall)
.07 = (ProbabilityRise)(.2147) + (1 – ProbabilityRise)(–.2638)
ProbabilityRise = .6976, or 69.76%

And the risk-neutral probability of a decline in the company value is:

ProbabilityFall = 1 – ProbabilityRise
ProbabilityFall = 1 – .6976
ProbabilityFall = .3024, or 30.24%

Using these risk-neutral probabilities, we can determine the expected payoff

to the equityholders’ call option at expiration, which will be:

Expected payoff at expiration = (.6976)($48,000,000) + (.3024)($0)

Expected payoff at expiration = $33,483,076.92

Since this payoff occurs 1 year from now, we must discount it at the risk-free
rate in order to find its present value. So:

PV(Expected payoff at expiration) = $33,483,076.92/1.07

PV(Expected payoff at expiration) = $31,292,595.26

Therefore, the current value of the company’s equity is $31,292,595.26. The

current value of the company is equal to the value of its equity plus the value
of its debt. In order to find the value of company’s debt, subtract the value
of the company’s equity from the total value of the company:

VL = Debt + Equity
$163,000,000 = Debt + $31,292,595.26
Debt = $131,707,404.74

b. To find the price per share, we can divide the total value of the equity by the
number of shares outstanding. So, the price per share is:

Price per share = Total equity value/Shares outstanding

Price per share = $31,292,595.26/500,000
Price per share = $62.59
c. The market value of the firm’s debt is $131,707,404.74. The present value of
the same face amount of riskless debt is $140,186,915.89 (=
$150,000,000/1.07). The firm’s debt is worth less than the present value of
riskless debt since there is a risk that it will not be repaid in full. In other
words, the market value of the debt takes into account the risk of default.
The value of riskless debt is $140,186,915.89. Since there is a chance that the
company might not repay its debtholders in full, the debt is worth less than
$140,186,915.89.

d. The value of the company today is $163 million. It will either increase to $217
million or decrease to $105 million in one year as a result of the new project.
If the firm’s value increases to $217 million, the equityholders will exercise
their call option, and they will receive a payoff of $67 million at expiration.
However, if the firm’s value decreases to $105 million, the equityholders will
not exercise their call option, and they will receive no payoff at expiration.

Equityholders’ call option price with a strike of $150

Value of company (in millions) (in millions)

Today 1 year Today 1 year

$217 $67 =Max($217 – 150, 0)

$163 ?

$105 $0 =Max($105 – 150, 0)

If the project is successful and the company’s value rises, the increase in the
value of the company over the period is 33.13 percent (= $217/$163 – 1). If
the project is unsuccessful and the company’s value falls, the decrease in the
value of the company over the period is –35.58 percent (= $105/$163 – 1).
We can use the following expression to determine the risk-neutral probability
of an increase in the value of the company:

Risk-free rate = (ProbabilityRise)(ReturnRise) + (ProbabilityFall)(ReturnFall)

Risk-free rate = (ProbabilityRise)(ReturnRise) + (1 – ProbabilityRise)(ReturnFall)
.07 = (ProbabilityRise)(.3313) + (1 – ProbabilityRise)(–.3558)
ProbabilityRise = .6197, or 61.97%

So the risk-neutral probability of a decrease in the company value is:

ProbabilityFall = 1 – ProbabilityRise
ProbabilityFall = 1 – .6197
ProbabilityFall = .3803, or 38.03%

Using these risk-neutral probabilities, we can determine the expected payoff

to the equityholders’ call option at expiration, which is:

Expected payoff at expiration = (.6197)($67,000,000) + (.3803)($0)

Expected payoff at expiration = $41,522,053.57

Since this payoff occurs 1 year from now, we must discount it at the risk-free
rate in order to find its present value. So:

PV(Expected payoff at expiration) = $41,522,053.57/1.07

PV(Expected payoff at expiration) = $38,805,657.54

Therefore, the current value of the firm’s equity is $38,805,657.54.

The current value of the company is equal to the value of its equity plus the
value of its debt. In order to find the value of the company’s debt, we can
subtract the value of the company’s equity from the total value of the
company, which yields:

VL = Debt + Equity
$163,000,000 = Debt + $38,805,657.54
Debt = $124,194,342.46

The riskier project increases the value of the company’s equity and decreases
the value of the company’s debt. If the company takes on the riskier project,
the company is less likely to be able to pay off its bondholders. Since the risk
of default increases if the new project is undertaken, the value of the
company’s debt decreases. Bondholders would prefer the company to
undertake the more conservative project.