A. Fethe Inc. is a custom manufacturer of guitars, mandolins, and other stringed instruments and is located near Knoxville, Tennessee. 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%, and the standard deviation of returns for companies similar to Fethe is 50%. Fethe's owners view their equity investment as an option and they would like to know the value of their investment. a. Using the Black-Scholes option pricing model, how much is Fethe's equity worth? b. How much is the debt worth today? What is its yield? c. How would the equity value and the yield on the debt change if Fethe's managers could use risk management techniques to reduce its volatility to 30%? Can explain this? you
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Trending now
This is a popular solution!
Step by step
Solved in 4 steps with 4 images
