A firm has assets of $21.8 million and a 3-year,zero-coupon,risky bonds with a total face value of $8.5 million.The bonds have a total current market value of $8.1 million.How can the shareholders of this firm change these risky bonds into risk-free bonds?

Question

Quizplus · Accepted Answer

To change the risky bonds into risk-free bonds, the shareholders need to eliminate the risk associated with the bonds. The best way to do this would be to purchase a put option, which would give them the right to sell the bonds at a predetermined price. Since the bonds have a total current market value of $8.1 million, the shareholders should purchase a put option with a 3-year life and an $8.5 million face value, which will allow them to sell the bonds for a guaranteed price of $8.5 million at the end of the 3-year period. This will eliminate the risk associated with the bonds and convert them into risk-free bonds. Option E is the only choice that offers a put option with the appropriate terms.

A Firm Has Assets of $21