Suppose you are the manager and sole owner of a highly leveraged company. All the debt matures in 1 year (there are no intermediate coupons or other debt payments). If at that time the value of the company (VA) is greater than the face value of debt (K), you will pay off the debt. If the value of the company is less than the face value of the debt, you will declare bankruptcy and the debt holders will own the company.
a. Express your position payoff as sole shareholder as a function of the value of the assets of the company. What option do you hold?
b. Express the position payoff of the debt holders in terms of options on the value of the assets of the company. What position do creditors hold?
c. Suppose your company’s assets are worth $19 million. Your company owes debt with face value of $20 million in 1 year. The risk-free interest rate is 4%. You value your equity position at $1 million. What should be the market value of the company’s debt? What rate of interest are debt holders earning?