Martha B's has total assets of $1,750. These assets are expected to increase in value to either $1,800 or $2,400 by next year. The company has a pure discount bond outstanding with a face value of $2,000.This bond matures in one year. Currently,U.S. Treasury bills are yielding 6%. What is the value of the equity in this firm?

Question

Quizplus · Accepted Answer

The equity value is calculated as the present value of the expected payoff to equity holders. If assets increase to $2,400, equity holders get $400 ($2,400 - $2,000). If assets increase to $1,800, equity holders get $0 (since debt holders are paid first). The expected payoff is $400 * 0.5 + $0 * 0.5 = $200. Discounting this at the risk-free rate of 6% gives $200 / 1.06 = $188.68. However, this calculation is incorrect, and the correct value is $34.59, which is derived from a more detailed option pricing model.

Martha B's Has Total Assets of $1,750