Problem:
Fethe Inc. is a custom manufacturer of guitars, mandolins, and other stringed instruments located near Knoxville, Tennessee. Fethe's current value of operations, which is also its value of debt plus equity, is estimated to be $5 million. Fethe has $2 million face-value zero coupon debt that is due in 2 years. The risk-free rate is 6%, and the standard deviation of returns for companies similar to Fethe is 50%. Fethe's owners view their equity investment as an option and would like to know the value of their investment.
1) Using the Black-Scholes Option Pricing Model, how much is Fethe's equity worth?
2) How much is the debt worth today? What is the yield?
3) How would the equity value and the yield on the debt change if Fethe's managers were able to use risk management techniques to reduce its volatility to 30%? Explain this.