Answers and Solutions: 17 - 2 h. When a firm has debt outstanding it can choose to default if the firm is not worth more than the face value of the debt. This decision to default when the value of the firm is low is like the decision not to exercise a call option when the stock price is low. If management (and hence the stockholders) make the debt payment, they get to keep the company. This makes equity like an option on the underlying value of the entire firm, with a strike price equal to the face value of the debt. If D is the face value of debt maturing in one year and S is the value of the entire firm (the firm’s debt plus equity) then the payoff to the stockholder when the debt matures is: Payoff = max(S-D, 0). This is the same payoff as a call option on S with a strike, or exercise, price of D. 17-2 Modigliani and Miller show that the value of a leveraged firm must be equal to the value of an unleveraged firm. If this is not the case, investors in the leveraged firm will sell their shares (assume they owned 10%). They will then borrow an amount
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