Reference no: EM133501807
Problem: Corporate Derivatives Study
Question I. When would an increase in volatility of firm value increase the value of junior debt, and when would an increase reduce the value of junior debt?
Question II. When would an increase in volatility of firm value increase the value of convertible debt, and when would an increase reduce the value of convertible debt?
Question III. The market share of Seattle Mills is $407 million. The claims on Seattle Mills are split between common stock and a 12% debt that has a face value of $350 million and that matures in five months. (The bondholders are supposed to receive the face value plus a 6% interest payment in five months.) Seattle's total market value is expected to grow 15% per year, and its volatility is 45% per year. If the non-annualized five- month interest rate is 2%, what is the current value of Seattle's equity? Is the debt riskless?
Question IV. Stevens Investment Properties holds a diversified portfolio of stocks, and has essentially no other assets. The total value of Stevens' assets is $200 million. The continuously compounded return on these assets is normally distributed, with a standard deviation of 25% per year. Stevens is owned by three groups of investors: senior debt, with a face value of $140 million; junior debt, with a face value of $100 million; and equity. Both the junior and senior debt mature in four years, and neither will receive any interest payments before maturity. Covenants in the debt contracts prohibit Stevens from making any dividend payments before the junior and senior debt are paid in full. If the risk free interest rate will be 4% a year for the next three years, what is the value of each slice of the portfolio? Ignore transaction costs and show your work.