Vatsug, Inc. is an unlevered firm that has 50,000 shares outstanding, each priced at $40. The firm decides to immediately borrow $1,000,000 for 10 years at a 6% interest rate. Assuming a marginal tax rate of 34%, what is your estimate of Vatsug's value as a levered firm?
In the 1960s, life insurance companies were signing up baby boomers for whole life policies. A feature often included in the policies was the right to borrow against the cash value of the policy at a fixed rate of interest, say 8 percent. At the time, with interest rates of 3 to 4 percent, this feature didn't seem important. However, this feature proved extremely valuable to the insured, when interest rates soared to double digits in the early 1980s. Suddenly, the baby boomers were able to borrow at 8 percent and invest at 12 percent, while the insurance companies had to borrow at rates higher than 8 percent in order to honor their contracts. Many insurers were threatened with insolvency because of this feature in their contracts.
a. What kind of option position did the insurance companies have? (Long or Short? European or American? Put or Call?) Explain your answer.
b. What is the underlying asset for the options in this real-life example?