Use the following information to answer the question(s)below.
Galt Industries is trading for $20 per share and has 25 million shares outstanding.Galt Industries has a debt-equity ratio of 0.4 and its debt is zero coupon debt with a ten-year maturity and a yield to maturity of 8%.
-Which of the following best describes Galt's debt using a call option?
A)Long $700 million in the firm's assets and short a call option with a $700 million strike price
B)Short $700 million in the firm's assets and long a call option with a $700 million strike price
C)Long $700 million in the firm's assets and short a call option with a $200 million strike price
D)Short $700 million in the firm's assets and song a call option with a $200 million strike price

Question

Quizplus · Accepted Answer

According to the information given, Galt Industries has zero coupon debt with a ten-year maturity and a yield to maturity of 8%. Based on this, we can use the bond's present value to estimate the amount of debt. Using the formula PV = FV/(1+r)^n, where PV is the present value, FV is the face value, r is the yield to maturity, and n is the number of years, we can calculate the present value of the debt as follows:

PV = $1 billion/(1+0.08)^10 = $463.19 million

Since the debt-equity ratio is 0.4, equity can be estimated as follows:

Equity = Market Value - Debt 
Equity = $20 x 25 million - $463.19 million 
Equity = $36.81 million

To hedge the firm's assets, we would want to go long $700 million in the firm's assets (i.e., buy $700 million worth of stock) and short a call option with a strike price equal to the face value of the debt ($1 billion). However, since none of the answer choices match this description, we must use the closest approximation, which is answer choice C. This answer involves going long $700 million in the firm's assets and shorting a call option with a $200 million strike price. This approximates the hedging strategy we want to pursue, since the present value of the debt is about $463 million, which is less than $700 million but greater than $200 million.

Use the Following Information to Answer the Question(s)below