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Explanation:
Under the Merton model framework, a firm's equity can be viewed as a European call option on the firm's assets with a strike price equal to the face value of the debt.
At maturity :
The payoff to equity holders is E_T = \max(V_T - D, 0) = \max(80 - 100, 0) = \`0$. The payoff to debt holders is $\min(V_T, D) = \min(80, 100) = \ million.
Because the firm value at maturity is less than the principal amount of the debt, the firm defaults, leaving the equity holders with nothing and the debt holders with the remaining assets of the firm (`$80` million). Therefore, Option A is correct.
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Q.3 Since it was founded ten years ago, Bright Technologies pays no dividends to shareholders and is financed with 100% equity. Recently, management decided to have the firm leveraged and issued a zero-coupon bond with a principal amount of $100 million maturing in exactly three years. If the value of the firm at maturity is $80 million, determine the values of the different components of the firm’s capital structure at the maturity date of the bond.
A
Value of equity = $0; value of debt = $80 million
B
Value of equity = $20 million; value of debt = $80
C
Value of equity = $180 million; value of debt = $100 million
D
Value of equity = $20 million; value of debt = $0