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CHAPTER 25 OPTIONS AND CORPORATE SECURITIES

Learning Objectives LO1 The basics of call and put options and how to calculate their payoffs and profits. LO2 The factors that affect option values and how to price call and put options using no arbitrage conditions. LO3 The basics of employee stock options and their benefits and disadvantages. LO4 How to value a firms equity as an option on the firms assets and use of option valuation to evaluate capital budgeting projects. LO5 The basics of convertible bonds and warrants and how to value them. Answers to Concepts Review and Critical Thinking Questions 1 !LO1" A call option confers the right, without the obligation, to buy an asset at a given price on or before a given date. A put option confers the right, without the obligation, to sell an asset at a given price on or before a given date. ou would buy a call option if you e!pect the price of the asset to increase. ou would buy a put option if you e!pect the price of the asset to decrease. A call option has unlimited potential profit, while a put option has limited potential profit" the underlying assets price cannot be less than #er . !LO1" a. The buyer of a call option pays money for the right to buy.... b. The buyer of a put option pays money for the right to sell.... c. The seller of a call option receives money for the obligation to sell.... d. The seller of a put option receives money for the obligation to buy.... !LO1" The intrinsic value of a call option is $a! %& ' (,)*. +t is the value of the option at e!piration. !LO1" The value of a put option at e!piration is $a!%( ' &,)*. ,y definition, the intrinsic value of an option is its value at e!piration, so $a!%( ' &,)* is the intrinsic value of a put option. !LO2" The call is selling for less than its intrinsic value" an arbitrage opportunity e!ists. ,uy the call for -.), e!ercise the call by paying -/0 in return for a share of stock, and sell the stock for -0). ouve made a riskless -0 profit. !LO2" The prices of both the call and the put option should increase. The higher level of downside risk still results in an option price of #ero, but the upside potential is greater since there is a higher probability that the asset will finish in the money. !LO2" 1alse. The value of a call option depends on the total variance of the underlying asset, not just the systematic variance. !LO1" The call option will sell for more since it provides an unlimited profit opportunity, while the potential profit from the put is limited 2the stock price cannot fall below #ero3. !LO2" The value of a call option will increase, and the value of a put option will decrease. !LO1" The reason they dont show up is that the government uses cash accounting" i.e., only actual cash inflows and outflows are counted, not contingent cash flows. 1rom a political perspective, they would make the deficit larger, so that is another reason not to count them4 5hether they should be included depends on whether we feel cash accounting is appropriate or not, but these contingent liabilities should be measured and reported. They currently are not, at least not in a systematic fashion.

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(olutions to Questions and )ro*le+s NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. ue to space and readability constraints! when these intermediate steps are included in this solutions manual! rounding may appear to have occurred. "owever! the final answer for each problem is found without rounding during any step in the problem. Basic 1 !LO2" a. The value of the call is the stock price minus the present value of the e!ercise price, so8 9) : -;< ' %-=0>..)=/* : -6/.?0 The intrinsic value is the amount by which the stock price e!ceeds the e!ercise price of the call, so the intrinsic value is -66. b. The value of the call is the stock price minus the present value of the e!ercise price, so8 9) : -;< ' %-/0>..)=/* : -//.== The intrinsic value is the amount by which the stock price e!ceeds the e!ercise price of the call, so the intrinsic value is -/6. c. 2 The value of the put option is -) since there is no possibility that the put will finish in the money. The intrinsic value is also -).

!LO1" a. The calls are not in the money. The intrinsic value of the calls is -). b. c. The puts are in the money. The intrinsic value of the puts is -?0 ' ?= : .. The $ar call is out of the money. The @ctober put is mispriced because it sells for less than the Auly put. To take advantage of this, sell the Auly put for -.).?0 and buy the @ctober put for -.).=0, for a cash inflow of -).=). The e!posure of the short position is completely covered by the long position in the @ctober put, with a positive cash inflow today.

!LO1" a. (ach contract is for .)) shares, so the total cost is8 9ost : .)2.)) shares>contract32-).6/3 9ost : -6/) b. +f the stock price at e!piration is -/), the payoff is8 Bayoff : .)2.))32-/) ' 6?3 Bayoff : -6))) +f the stock price at e!piration is -6C, the payoff is8 Bayoff : .)2.))32-6C ' 6?3 Bayoff : -.,))) c. Demembering that each contract is for .)) shares of stock, the cost is8

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9ost : .)2.))32-6..)3 9ost : -6,.)) The ma!imum gain on the put option would occur if the stock price goes to -). 5e also need to subtract the initial cost, so8 $a!imum gain : .)2.))32-6?3 ' -6,.)) $a!imum gain : -60,C)) +f the stock price at e!piration is -6/, the position will have a profit of8 Brofit : .)2.))32-6? ' 6/3 ' -6,.)) Brofit : -6,C)) d. At a stock price of -60 the put is in the money. As the writer you will make8 Eet loss : -6,.)) ' .)2.))32-6? ' 603 Eet loss : '-C)) At a stock price of -/. the put is out of the money, so the writer will make the initial cost8 Eet gain : -6,.)) At the breakeven, you would recover the initial cost of -6,C)), so8 -6,.)) : .)2.))32-6? ' &T3 &T : -60.C) 1or terminal stock prices above -60.C), the writer of the put option makes a net profit 2ignoring transaction costs and the effects of the time value of money3. 4 !LO2" a. The value of the call is the stock price minus the present value of the e!ercise price, so8 9) : -?0 ' <0>..); 9) : -.=.60 b. Fsing the equation presented in the te!t to prevent arbitrage, we find the value of the call is8 -?0 : %2-C0 ' 0/3>2-C0 ' C)3*9) G -0/>..); 9) : -=..;< 5 !LO2" a. The value of the call is the stock price minus the present value of the e!ercise price, so8 9) : -<0 ' -;)>..); 9) : -.?./C; b. Fsing the equation presented in the te!t to prevent arbitrage, we find the value of the call is8 -<0 : ../?9) G -;=>..); 9) : -.).;/0

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!LO2" (ach option contract is for .)) shares of stock, so the price of a call on one share is8 9) : -.,.0)>.)) shares per contract 9) : -...0) Fsing the no arbitrage model, we find that the price of the stock is8 &) : -...0)%2-;? ' =<3>2-;? ' ;)3* G -=<>..)/ &) : -<0.?6

!LO4" a. The equity can be valued as a call option on the firm with an e!ercise price equal to the value of the debt8 $ethod .8 The two possible future asset values are equal or greater to the future value of debt, which implies that the debt is risk7free. 1or this special case where the debt is risk7free, we can calculate equity value as8 () : -.)= ' %-.))>..)0* () : -?.<; $ethod 68 The solution for the general case, which works for both risk7free and risky debt, is shown below8 The lower possible future asset value is equal to8 -.)) : min%-.)), -.6C* Deplicate this lower future asset value by investing today in the risk7free asset, at a present value of8 -.)) > ..)0 : -C0.6/? The e!ercise price of the option is the future value of the debt, equal to its face value of -.)). &o if the asset turns out to be worth the upper value of -.6C in one year, the option will then be worth8 -.6C 7 -.)) : -6C The required number of call options is then the upper future value minus the lower future value, divided by the value of the option8 2-.6C 7 -.))3 > -6C : ..)) call options 5ith the firm is presently valued at -.)=, we can replicate the value of the firm as8 -.)= : ..)) 9) G -C0.6/? 9) : -?.<;6 b. The current value of debt is the value of the firms assets minus the value of the equity, so8 H) : -.)= ' ?.<;6 H) : -C0.6/? 5e can use the face value of the debt and the current market value of the debt to find the interest rate, so8 +nterest rate : %-.))>-C0.6/?* ' . +nterest rate : .)0 or 0I The calculated interest rate is equal to the risk free rate because the value of the firms assets is always equal to or greater than the face value of debt, and therefore the debt is risk7free.

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Eote that if the lower possible future value was below the face value of debt, for e!ample the two possible future values were -.)) and -.6C, then the debt would be risky and the calculated interest rate would have turned out to be greater than the risk free rate. c. % The value of the equity will increase. The debt then requires a higher return" therefore the present value of the debt is less while the value of the firm does not change.

!LO4" a. Fsing the no arbitrage valuation model, we can use the current market value of the firm as the stock price, and the par value of the bond as the strike price to value the equity. Hoing so, we get8 -.)C : %2-./? ' C63>2-./? ' .))3*() G %-C6>..);* () : -.?./=0 The current value of the debt is the value of the firms assets minus the value of the equity, so8 H) : -.)C ' .?./=0 H) : -C).;0 b. Fsing the no arbitrage model as in part a, we get8 -.)C : %2-.;) ' ?)3>2-.;) ' .))3*() G %-?)>..);* () : 60..=; The stockholders will prefer the new asset structure because their potential gain increases.

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!LO5" The conversion ratio is the par value divided by the conversion price, so8 9onversion ratio : -.))>-6? 9onversion ratio : /.0<.=6?0<. The conversion value is the conversion ratio times the stock price, so8 9onversion value : /.0<.=6?0<. 2-/<3 9onversion value : -./6..=/

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!LO5" a. The minimum bond price is the greater of the straight bond value or the conversion value. The straight bond value is8 &traight bond value : -6.<)2BJ+1A/.0)I,;)3 G -.))>..)/0;) &traight bond value : -?).)= The conversion ratio is the par value divided by the conversion price, so8 9onversion ratio : -.))>-/0 9onversion ratio : 6.?0<.=6?0< The conversion value is the conversion ratio times the stock price, so8 9onversion value : 6.?0<.=6?0< 2-/=3 9onversion value : -C<..=6?0<.= The minimum value for this bond is the convertible floor value of -C<..=.

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The option embedded in the bond adds the e!tra value.

!LO5" a. The minimum bond price is the greater of the straight bond value or the conversion value. The straight bond value is8 &traight bond value : -<.02BJ+1ACI,/)3 G -.))>..)C/) &traight bond value : -?=.0C The conversion ratio is the par value divided by the conversion price, so8 9onversion ratio : -.))>-0.0 9onversion ratio : .?..?6 The conversion price is the conversion ratio times the stock price, so8 9onversion value : .?..?62-=.63 9onversion value : -<;./;/; The minimum value for this bond is the straight value of -?=.0C. b. The conversion premium is )

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!LO5" The value of the bond without warrants is8 &traight bond value : -0.02BJ+1A<I,603 G -.))>..)<60 &traight bond value : -?6.06 The value of the warrants is the selling price of the bond minus the value of the bond without warrants, so8 Total warrant value : -.)) ' ?6.06 Total warrant value : -.<.=? &ince the bond has 6) warrants attached, the price of each warrant is8 Brice of one warrant : -.<.=?>6) Brice of one warrant : -).?<=

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!LO4" +f we purchase the machine today, the EBJ is the cost plus the present value of the increased cash flows, so8 EBJ) : '-.,;)),))) G -/.),)))2BJ+1A.=I,.)3 EBJ) : -.;,CC0.?0 5e should purchase the machine today because the EBJ is positive. 5e would want to purchase the machine when the EBJ is the highest positive value. &o, we need to calculate the EBJ each year. The EBJ each year will be the cost plus the present value of the increased cash savings. 5e must be careful however. +n order to make the correct decision, the EBJ for each year must be taken to a common date. 5e will discount all of the EBJs to today. Hoing so, we get8

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ear .8 EBJ. : %'-.,0)0,))) G -/.),)))2BJ+1A.=I,C3* > ...= EBJ. : 6=,?C).0C ear 68 EBJ6 : %'-.,=.),))) G -/.),)))2BJ+1A.=I,?3* > ...=6 EBJ6 : 6.,0?..?? ear /8 EBJ/ : %'-.,/.0,))) G -/.),)))2BJ+1A.=I,<3* > ...=/ EBJ/ : -C,<)6./< ear =8 EBJ= : %'-.,66),))) G -/.),)))2BJ+1A.=I,;3* > ...== EBJ= : '-?,0C6.C) ear 08 EBJ0 : %'-.,.60,))) G -/.),)))2BJ+1A.=I,03* > ...=0 EBJ0 : '-/.,0=?.CC ear ;8 EBJ; : %'-.,.60,))) G -/.),)))2BJ+1A.=I,=3* > ...=; EBJ; : '-.).,)60.C0 The EBJ is the highest one year from now. Intermediate 14 !LO4" a. The base7case EBJ is8 EBJ : '-.,;)),))) G -=)C,0))2BJ+1A.=I,.)3 EBJ : -0/0,CCC./0 b. 5e would abandon the project if the cash flow from selling the equipment is greater than the present value of the future cash flows. 5e need to find the sale quantity where the two are equal, so8 -.,6)),))) : 2-;/3K2BJ+1A.=I,C3 K : -.,6)),))) > %-;/2=.C=;/<.?/<3* K : /?0).?/ Abandon the project if K L /?0).0; units, because the EBJ of abandoning the project is greater than the EBJ of the future cash flows. c. 15 The -.,6)),))) is the market value of the project. +f you continue with the project in one year, you forego the -.,6)),))) that could have been used for something else.

!LO4" a. +f the project is a success, present value of the future cash flows will be8 BJ future 91s : -;/2C,)))32BJ+1A .=I,C3 BJ future 91s : -6,?)=,0C6.?/ 1rom the previous question, if the quantity sold is/,0)), we would abandon the project, and the cash flow would be -.,6)),))). &ince the project has an equal likelihood of success or failure in one year, the e!pected value of the project in one year is the average of the success and failure cash flows, plus the cash flow in one year, so8 (!pected value of project at year . : %2-6,?)=,0C6.?/G -.,6)),)))3>6* G -=)C,0)) (!pected value of project at year . : -6,=..,<C;.=6

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The EBJ is the present value of the e!pected value in one year plus the cost of the equipment, so8 EBJ : '-.,;)),))) G 2-6,=..,<C;.=63>...= EBJ : -0.0,;.).?C b. +f we couldnt abandon the project, the present value of the future cash flows when the quantity is /,0)) will be8 BJ future 91s : -;/2/,0))32BJ+1A .=I,C3 BJ future 91s : -.,)C),;<=.CC The gain from the option to abandon is the abandonment value minus the present value of the cash flows if we cannot abandon the project, so8 Main from option to abandon : -.,6)),))) ' .,)C),;<=.CC Main from option to abandon : -.)C,/60.). 5e need to find the value of the option to abandon times the likelihood of abandonment. &o, the value of the option to abandon today is8 @ption value : 2.0)32- .)C,/60.).3>...= @ption value : -=<,C=C.0< 1# !LO4" +f the project is a success, present value of the future cash flows will be8 BJ future 91s : -;/2.?,)))32BJ+1A .=I,C3 BJ future 91s : -0,;)C,.?0.;; +f the sales are only /,0)) units, from Broblem N.= O .0, we know we will abandon the project, with a value of -.,6)),))). &ince the project has an equal likelihood of success or failure in one year, the e!pected value of the project in one year is the average of the success and failure cash flows, plus the cash flow in one year, so8 (!pected value of project at year . : %2-0,;)C,.?0.;; G -.,6)),)))3>6* G -=)C,0)) (!pected value of project at year . : -/,?.=,)C6.?/ The EBJ is the present value of the e!pected value in one year plus the cost of the equipment, so8 EBJ : '-.,;)),))) G -/,?.=,)C6.?/>...= EBJ : -.,<=0,;C0.=< The gain from the option to e!pand is the present value of the cash flows from the additional units sold, so8 Main from option to e!pand : -;/2C,)))32BJ+1A .=I,C3 Main from option to e!pand : -6,?)=,0C6.?/ 5e need to find the value of the option to e!pand times the likelihood of e!pansion. 5e also need to find the value of the option to e!pand today, so8 @ption value : 2.0)32- 6,?)=,0C6.?/3>...= @ption value : -.,6/),)?=.0< 1$ !LO2" a. The value of the call is the ma!imum of the stock price minus the present value of the e!ercise price, or #ero, so8 9) : $a!%-0= ' 2-;)>..)03,)* 9) : -)

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The option isnt worth anything. b. The stock price is too low for the option to finish in the money. The minimum return on the stock required to get the option in the money is8 $inimum stock return : 2-;) ' 0=3>-0= $inimum stock return : ..... or .....I which is much higher than the risk7free rate of interest. 1% 1& !LO5" , is the more typical case" A presents an arbitrage opportunity. ou could buy the bond for -?) and immediately convert it into stock that can be sold for -.)). A riskless -6) profit results. !LO5" a. The conversion ratio is given at 6). The conversion price is the par value divided by the conversion ratio8 9onversion price : -.))>6) 9onversion price : -0 The conversion premium is the percent increase in stock price that results in no profit when the bond is converted, so8 9onversion premium : 2-0 ' =.03>-=.0 9onversion premium : ..... or .....I b. The straight bond value is8 &traight bond value : -/.602BJ+1A=.0I,=)3 G -.))>..)=0=) &traight bond value : -<<.)) And the conversion value is the conversion ratio times the stock price, so8 9onversion value : 6)2-=.03 9onversion value : -C).)) c. 5e simply need to set the straight bond value equal to the conversion ratio times the stock price, and solve for the stock price, so8 -<< : 6)& & : -/.?0 d. There are actually two option values to consider with a convertible bond. The conversion option value, defined as the market value less the floor value, and the speculative option value, defined as the floor value less the straight bond value. 5hen the conversion value is less than the straight7bond value, the speculative option is worth #ero.

9onversion option value : -C; ' C) : -; &peculative option value : -C) ' << : -./ Total option value : -;.)) G ./ : -.C.))

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2' !LO4" a. The EBJ of the project is the sum of the present value of the cash flows generated by the project. The cash flows from this project are an annuity, so the EBJ is8 EBJ : '-/?,))),))) G -?,))),)))2BJ+1A..I,?3 EBJ : -/,.;?,C?6.)C b. The company should abandon the project if the BJ of the revised cash flows for the ne!t seven years is less than the projects afterta! salvage value. &ince the option to abandon the project occurs in ear ., discount the revised cash flows to ear . as well. To determine the level of e!pected cash flows below which the company should abandon the project, calculate the equivalent annual cash flows the project must earn to equal the afterta! salvage value. 5e will solve for 96, the revised cash flow beginning in ear 6. &o, the revised annual cash flow below which it makes sense to abandon the project is8 Afterta! salvage value : #62BJ+1A..I,<3 -60,))),))) : #62BJ+1A..I,C3 #6 : -60,))),))) > BJ+1A..I,< #6 : -0,/)0,/?..<=
Challenge 21 !LO5" The straight bond value today is8 &traight bond value : -=.?2BJ+1A?I,603 G -.))>..)?60 &traight bond value : -;0.?= And the conversion value of the bond today is8 9onversion value : -/.6.2-.))>-C3 9onversion value : -/0.;< 5e e!pect the bond to be called when the conversion value increases to -./), so we need to find the number of periods it will take for the current conversion value to reach the e!pected value at which the bond will be converted. Hoing so, we find8 -/0.;<2....3t : -./) t : ln2./)>/0.;<3 > ln2....3 : .6./C years. The bond will be called in .6./C years. The bond value is the present value of the e!pected cash flows. The cash flows will be the annual coupon payments plus the conversion price. The present value of these cash flows is8 ,ond value : -=.?2BJ+1A?I,.6./C3 G -./)>..)?.6./C : -<0.=. 22 !LO4" 5e will use the bottom up approach to calculate the operating cash flow. Assuming we operate the project for all four years, the cash flows are8 ear &ales @perating costs ) . -.),C)),))) =,.)),))) 6 -.),C)),))) =,.)),))) / .),C)),))) =,.)),))) = .),C)),))) =,.)),)))

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Hepreciation (,T Ta! Eet income GHepreciation @perating 91 9hange in E59 9apital spending Total cash flow '-C)),))) '.0,))),))) '-.0,C)),)))

/,<0),))) /,)0),))) .,.0C,))) .,?C.,))) /,<0),))) 0,;=.,))) ) ) -0,;=.,)))

/,<0),))) /,)0),))) .,.0C,))) .,?C.,))) /,<0),))) 0,;=.,))) ) ) -0,;=.,)))

/,<0),))) /,)0),))) .,.0C,))) .,?C.,))) /,<0),))) 0,;=.,))) ) ) -0,;=.,)))

/,<0),))) /,)0),))) .,.0C,))) .,?C.,))) /,<0),))) 0,;=.,))) C)),))) ) -;,0=.,)))

There is no salvage value for the equipment. The EBJ is8 EBJ : '-.0,C)),))) G -0,;=.,))) 2BJ+1A./I,/3 G -;,0=.,)))>.../= EBJ : -.,=/),C<C.;)

The cash flows if we abandon the project after one year are8 ear &ales @perating costs Hepreciation (,T Ta! Eet income GHepreciation @perating 91 9hange in E59 9apital spending Total cash flow '-C)),))) '.0,))),))) '-.0,C)),))) ) . -.),C)),))) =,.)),))) /,<0),))) -/,)0),))) .,.0C,))) -.,?C.,))) /,<0),))) -0,;=.,))) -C)),))) .6,//0,))) -.?,?<;,)))

The book value of the equipment is8 ,ook value : -.0,))),))) ' 2.32-.0,))),)))>=3 ,ook value : -..,60),))) &o the ta!es on the salvage value will be8 Ta!es : 2-..,60),))) ' ./,))),)))32./?3 Ta!es : '-;;0,))) This makes the afterta! salvage value8

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Afterta! salvage value : -./,))),))) ' ;;0,))) Afterta! salvage value : -.6,//0,))) The EBJ if we abandon the project after one year is8 EBJ : '-.0,C)),))) G -.?,?<;,)))>...= EBJ : ?)=,=6=.<?

+f we abandon the project after two years, the cash flows are8 ear &ales @perating costs Hepreciation (,T Ta! Eet income GHepreciation @perating 91 9hange in E59 9apital spending Total cash flow '-C)),))) '.0,))),))) '-.0,))),))) ) . -.),C)),))) =,.)),))) /,<0),))) /,)0),))) .,.0C,))) .,.?C,))) /,<0),))) 0,;=.,))) ) ) -0,;=.,))) 6 .),C)),))) =,.)),))) /,0<),))) /,)0),))) .,.0C,))) .,.?C,))) /,/<0,))) 0,;=.,))) C)),))) C,)0),))) -.0,0C.,)))

The book value of the equipment is8 ,ook value : -.0,))),))) ' 2632-.0,))),)))>=3 ,ook value : -<,0)),))) &o the ta!es on the salvage value will be8

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Ta!es : 2-<,0)),))) ' .),))),)))32./?3 Ta!es : '-C0),)))

This makes the afterta! salvage value8 Afterta! salvage value : -.),))),))) 'C0),))) Afterta! salvage value : -C,)0),))) The EBJ if we abandon the project after two years is8 EBJ : '-.0,C)),))) G -0,;=.,)))>...= G -.0,0C.,)))>...=6 EBJ : -.,/)6,)<0./=

+f we abandon the project after three years, the cash flows are8 ear &ales @perating costs Hepreciation (,T Ta! Eet income GHepreciation @perating 91 9hange in E59 9apital spending Total cash flow '-C)),))) '.0,))),))) '-.0,C)),))) ) . -.),C)),))) =,.)),))) /,<0),))) /,)0),))) .,.0C,))) .,?C.,))) /,<0),))) 0,;=.,))) ) ) 0,;=.,))) 6 .),C)),))) =,.)),))) /,<0),))) /,)0),))) .,.0C,))) .,?C.,))) /,<0),))) 0,;=.,))) ) ) 0,;=.,))) / .),C)),))) =,.)),))) /,<0),))) /,)0),))) .,.0C,))) .,?C.,))) /,<0),))) 0,;=.,))) C)),))) ;,)<0,))) .6,;.;,)))

The book value of the equipment is8 ,ook value : -.0,))),))) ' 2/32-.0,))),)))>=3 ,ook value : -/,<0),))) &o the ta!es on the salvage value will be8

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Ta!es : 2-/,<0),))) ' <,0)),)))32./?3 Ta!es : '-.,=60,))) This makes the afterta! salvage value8 Afterta! salvage value : -<,0)),))) ' .,=60,))) Afterta! salvage value : -;,)<0,))) The EBJ if we abandon the project after two years is8 EBJ : '-.0,C)),))) G -0,=;.,)))2BJ+1A.=I,63 G -.6,;.;,)))>...;/ EBJ : -6,60/,6?;.;C 5e should abandon the equipment after three years since the EBJ of abandoning the project after three years has the highest EBJ.

APPENDIX 25A A1 Accurate values for the standard normal distribution are used here based on (!cels E@D$&H+&T function. +f standard normal values are taken from Table 60A.. instead, the final value for the option will differ slightly. a. b. c. d. e. f. g. h. d. : '..0C/<6; " d6 : '..;C?<6; " E2d.3 : .)00=C" E2d63 : .)==;? 9) : -/..))2.)00=C3 ' %/<.0)>..)<.>=*2.)==;?3 : -).)</ d. : /.66;=" d6 : /..6)/" E2d.3 : .CCC=" E2d63 : .CCC. 9) : -=)2.CCC=3 ' %6C>..)/.>6*2.CCC.3 : -...=/ d. : 6..CC6" d6 : ..CC.=" E2d.3 : .C?;." E2d63 : .C<;? 9) : -?C2.C?;.3 ' %;/>...6/>=*2.C<;?3 : -/..6= d. : ./=?;" d6 : .)=?;" E2d.3 : .;/;/" E2d63 : .0.C= 9) : -C<2.;/;/3 ' %CC>..)?*2.0.C=3 : -.=... &) : ), so 9) : ) T : P, so 9) : &) : -.60 ( : ), so 9) : &) : -.6C : ), so d. and d6 go to GP, so E2d.3 and E2d63 go to .. This is the no risk call option formula given in the te!t. 9) : &) ' (>2.G$3t " 9) : -.6. ' %../>..);.>6* : -...6= for : P, d. goes to GP so E2d.3 goes to ., and d6 goes to 'P so E2d63 goes to )" 9): &) : -0)

i.

607.=

A2 Fsing & : -/,=)), ( : -6,C0), t : ., $ : .)=0, : .6C : ).0/?08 d. : .;.;0" d6 : .)<<C" E2d.3 : .</.6" E2d63 : .0/.. Jalue of equity : -/,=))2.</.63 ' %6,C0)>..)=0*2.0/..3 : -C?;.C6 Jalue of debt : -/,=)) ' C?;.C6 : -6,=./.)? A3 a. Broject A8 using & : -/,=)) G -./0 : -/,0/0, ( : -6,C0), t : ., $ : .)=0, : ./C : ).;6=08 d. : .;C=)" d6 : .)=C0" E2d.3 : .<=C?" E2d63 : .0.C< Jalue of equityA : -/,0/02.<=C?3 ' %6,C0)>..)=0*2.0.C<3 : -.,.?/.=C Jalue of debtA : -/,0/0 ' .,.?/.=C : -6,/0..0. using & : -/,=)) G -6.0 : -/,;.0, ( : -6,C0), t : ., $ : .)=0, : .66 : ).=;C)8 d. : .<;/C" d6 : .6C=?" E2d.3 : .<<<0" E2d63 : .;.0C Jalue of equity, : -/,;.02.<<<03 ' %6,C0)>..)=0*2.;.0C3 : -.,)<..CC Jalue of debt, : -/,;.0 ' .,)<..CC : -6,0=/.).

Broject ,8

b.

Although the EBJ of project , is higher, the equity value with project A is higher. 5hile EBJ represents the increase in the value of the assets of the firm, in this case, the increase in the value of the firms assets resulting from project , is mostly allocated to the debtholders resulting in a smaller increase in the value of the equity. &tockholders would therefore prefer project A even though it has a lower EBJ. es. +f the same group of investors has equal stakes in the firm as bondholders and stockholders, then total firm value matters and project , should be chosen, since it increases the value of the firm to -/,;.0 instead of -/,0/0.

c.

d.

Stockholders may have an incentive to take on more risky, less profitable projects if the firm is leveraged; all else the same, the higher the firms debt load the greater is this incentive.

607.0

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