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Suppose a firm has two debt issues outstanding. One is a senior debt issue that matures in three years with a principal amount of $100 million. The other is a subordinate debt issue that also matures in three years with a principal amount of $50 million. The annual interest rate is 5 percent and the volatility of the firm value is estimated to be 15 percent. In the Merton model the value of equity is calculated as:
A. I only.
B. II and IV only.
C. I and II only.
D. III only.
Answer:D
Statement III is correct. The value of equity is the difference between the value of the firm less the value of both senior and subordinate debt. The value of equity as a call option would have an exercise price equal to the face value of senior debt plus the face value of subordinate debt ($100 million plus $50 million). The difference between the value of the firm and a call option with an exercise price of $150 million would be the value of senior debt.
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