Suppose a firm has a current market value of $900 and outstanding debt with a face value of $850. The risk-free rate of interest is 6%. If the firm will have a value of either $650 or $900 next period, what is the value of the equity in the firm?

Question

Quizplus · Accepted Answer

The equity value can be calculated using the risk-neutral valuation approach. The expected payoff to equity holders is the difference between the firm's value and the debt, only if the firm's value exceeds the debt. The risk-neutral probability of the firm being worth $900 is calculated using the risk-free rate. The expected payoff is then discounted back at the risk-free rate to find the present value of equity.

Suppose a Firm Has a Current Market Value of $900