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%, and the volatility of the firm value is estimated to be 15%. If interest rates decline in the Merton model, then which of the following is true?
A. If the firm is experiencing financial distress (low firm value), then the value of senior debt will increase while the values of subordinate debt and equity will both decline.
B. If the firm is not experiencing financial distress (high firm value), then the value of senior debt and subordinate debt and equity will increase.
C. If the firm is experiencing financial distress (low firm value), then the value of senior debt and subordinate debt will increase while equity values will decline.
D. If the firm is not experiencing financial distress (high firm value), then the value of senior debt will increase while the values of subordinate debt and equity will both decline.
Answer:A
When firms with subordinate debt are experiencing financial distress (low firm values), changes in the value of subordinate debt will react to changes in the model parameters in the same way as equity. Since equity is valued as a call option in the Merton model, a decline in interest rates will reduce the value of equity (and subordinate debt). When firms with subordinate debt are not experiencing financial distress (high firm values), changes in the value of subordinate debt will react to changes in the model parameters in the same way as senior debt. Since senior debt is valued as the difference in firm value less equity valued as a call option in the Merton model, a decline in interest rates will increase the value of senior debt and subordinate debt.