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Relationship between Equity Value and Volatility

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Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company's EBIT was $120 million last year and is not expected to grow. Pizza Palace is in the 25% state-plus-federal tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent. The firm is currently financed with all equity and it has 10 million shares outstanding.

j. Liu Industries is a highly levered firm. Suppose there is a large probability that Liu will default on its debt. The value of Liu's operations is $4 million. The firm's debt consists of 1-year, zero coupon bonds with a face value of $2 million. Liu's volatility, σ, is 0.60 and the risk-free rate rRF is 6%.

Because Liu's debt is risky, its equity is like a call option and can be valued with the Black-Scholes Option Pricing Model (OPM).

(3) What incentives might the manager of Liu have if she understands the relationship between equity value and volatility? What might debtholders do in response?

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Solution Summary

The answer addresses the relationship between equity and debt values to volatility. It also addresses the concept of asset switching (bait and switch).

Solution Preview

Since the value of equity increases (hence the value of debt decreases), as volatility decreases; the manager might engage in asset switching (also known as "bait and switch"). ...

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