95.
Rackin Pinion Corporation’s assets are currently worth $1,260. In one year,
they will be worth either $1,200 of $1,610. The risk-free interest rate is 5
percent. Suppose Rackin Pinion has an outstanding debt issue with a face
value of $1,200. What is the current value of the firm’s debt?
96.
Buckeye Industries has a bond issue with a face value of $1,000 that is
coming due in one year. The value of Buckeye’s assets is currently $1,350.
Jim Tressell, the CEO, believes that the assets in the firm will be worth
either $600 or $1,700 in a year. The going rate on one-year T-bills is 6
percent. What is the current value of the firm’s debt?
97.
A $1,000 convertible debenture has a conversion price for common stock of
$85 per share. The common stock is selling at $92 a share. What is the
conversion value of this bond?
98.
A bond with 10 detachable warrants has just been offered for sale at
$1,000. The bond matures in 12 years and has an annual coupon of $80.
Each warrant gives the owner the right to purchase two shares of stock in
the company at $14 per share. Ordinary bonds (with no warrants) of similar
quality are priced to yield 11 percent. What is the value of one warrant?
99.
Your company is deciding when to invest in a new machine. The new
machine will increase cash flow by $240,000 per year. You believe the
technology used in the machine has a 10-year life; in other words, no matter
when you purchase the machine, it will be obsolete 10 years from today.
The machine is currently priced at $1,200,000. The cost of the machine will
decline by $120,000 per year until it reaches $720,000, where it will remain.
Your required return is 8 percent. In which year should you purchase the
machine?
100.
We are examining a new project. We expect to sell 9,500 units per year at
$48 net cash flow apiece for the next 20 years. In other words, the annual
operating cash flow is projected to be $45 × 9,000 = $405,000. The
relevant discount rate is 14 percent, and the initial investment required is
$1,730,000. After the first year, the project can be dismantled and sold for
$1,350,000. If expected sales are revised based on the first year’s
performance, it would make sense to abandon the investment if the sales
are less than which of the following number of units?
101.
We are examining a new project. We expect to sell 8,000 units per year at
$80 net cash flow apiece for the next 15 years. In other words, the annual
operating cash flow is projected to be $80 × 8,000 = $640,000. The
relevant discount rate is 16 percent, and the initial investment required is
$2,740,000. The project can be dismantled after the first year and sold for
$2,130,000. Suppose you think it is likely that expected sales will be revised
upward to 9,600 units if the first year is a success and revised downward to
3,000 units if the first year is not a success. Suppose the scale of the
project can be doubled in one year in the sense that twice as many units
can be produced and sold. Naturally, expansion would be desirable only if
the project is a success. This implies that if the project is a success,
projected sales after expansion will be 19,200. Assume that success and
failure are equally likely. Note that abandonment is still an option if the
project is a failure. What is the value of the option to expand?
Essay Questions
102.
Circle Stores stock is priced at $28 a share. A $40 call on this stock has five
months until expiration and a call price of $0.15. Why would an investor
purchase a call that is so far out of the money?
103.
What are the basic similarities and basic differences between warrants and
call options?
104.
What are the upper and lower bounds for an American call option? Explain
what would happen in each case if the bound was violated.
105.
Explain the rationale behind the idea that equity is a call option on a firm’s
assets. When would a shareholder allow this call to expire?
106.
Call options are frequently attached to bonds, making them callable at the
option of the issuer. Consider a firm that just issued two sets of bonds: One
is callable, has a 7 percent coupon rate, 15 years to maturity, and cannot be
called during the first three years; the second is noncallable, has a 7
percent coupon rate, 15 years to maturity, and is identical to the first bond
in every way except for the call option. Suppose the noncallable bonds are
sold for $1,000 each. Will the callable bonds sell for more or less than
$1,000? Who “purchases” the option in this case and who “sells” it?
107.
Explain how the floor and the ceiling prices for a convertible bond are
determined.