Assignment

Your boss now wants you to help Higgs Bassoon Corporation. Higgs Bassoon Corporation is a custom manufacturer of bassoons and other wind instruments. Its current value of operations, which is also its value of debt plus equity, is estimated to be $200 million. Higgs has zero coupon debt outstanding that matures in 3 years with $110 million face value. The risk-free rate is 5%, and the standard deviation of returns for similar companies is 60%. The owners of Higgs Bassoon view their equity investment as an option and would like to know its value. Start with the attached partial model, and answer the following questions:

• Using the Black-Scholes option pricing model, how much is the equity worth?

• How much is the debt worth today? What is its yield?

• How would the equity value change if the company used risk management techniques to reduce its volatility to 45%? Can you explain this?

• Graph the cost of debt versus the face value of debt for values of the face value from $10 to $160 million.

• Graph the values of debt and equity for volatilities from 0.10 to 0.90 when the face value of the debt is $100 million.