Your firm has a market value balance sheet of Assets ($20) = Debt (14.3) + Equity ($5.7), which we can call a Base Case. Other information is the face value of debt is $40, the debt matures in 5 years, the Asset return standard deviation = 50%, and the risk free rate is 4%. You have three mutually exclusive capital budgeting projects from which to choose.
Project A has an NPV of $4. Project A’s Standard Deviation is 40%. If Project A is accepted, the firm’s new Asset Value will be $24 and the new Debt Value will be 18.0.
Project B has an NPV of $2. Project B’s Standard Deviation is 60%. If Project B is accepted, the firm’s new Asset Value will be $22 and the new Debt Value will be 13.2.
Project C has an NPV of -$1. Project C’s Standard Deviation is 80%. If Project C is accepted, the firm’s new Asset Value will be $19 and the new Debt Value will be 12.7.
a. What is the value of the put option associated with the risky debt in Scenario A?
b. Considering accepting mutually exclusive Projects A, B, C, or rejecting all three projects, what is the optimal strategy? Why? You must use numbers correctly in your explanation to get partial credit.