Question

“If you are a stockholder, you prefer managers take on risky projects.” Provide the reason based...

  1. “If you are a stockholder, you prefer managers take on risky projects.” Provide the reason based on real options.
  2. A corporation doubled its debt holding recently. Please provide a real option-based reason why increased debt may affect the stockholders negatively.
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Homework Answers

Answer #1

1.

Equity can be viewed as a call option on firm's assets with strike price equal to face value of debt. We know that price of call increases when volatility increases. When risky projects are taken, volatility increases. Hence when risky projects are taken, value of call option increases i.e., value of equity increases.

2.

Equity can be viewed as a call option on firm's assets with strike price equal to face value of debt. We know that price of call decreases when strike price increases. When debt increases, strike price for call option increases. Thus value of call option decreases i.e., value of equity decreases.

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