BA350 Financial Management
Chapter 17 Problem 11 Build A Model
A. Fethe is a custom manufacturer of guitars, mandolins and other stringed instruments located near Knoxville, TN. 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 percent, and the volatility of companies similar to Fethe is 50 percent. Fethe's owners view their equity investment as an option and would like to know the value of their investment.
a. Graph the cost of debt versus the face value of debt for values of the face value from $0.5 to $8 million.
b. Graph the values of debt and equity for volatilities from 0.10 to 0.90 when the face value of the debt is $2 million.
c. Repeat part b, but instead using a face value of debt of $5 million. What can you say about the difference between the graphs in part b and part c?