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case12sol - Introduction to derivatives Fall 2011 BUSI 588...

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Introduction to derivatives, Fall 2011 BUSI 588, Case 12 solutions Solutions to MIM - risky debt, incentives and convertibles As a reference, recall the projects that MIM can invest in. NPV β A Firm vol B-flat major 5 1.19 80% B-flat minor 4 1.17 72% C-sharp major 4 1.31 98% C-sharp minor 6 1.28 90% 1. (*) Both debtholders and shareholders like projects with higher NPVs. On the other hand, equityholders also like volatility, since their payoffs are equivalent to those of a call option. Other things equal, the debtholders dislike volatility, since their payoffs are equivalent to short positions in options (either short calls or short puts). It should be emphasized that this preference for volatility is in an ex-post sense, i.e. in ex- ante terms both shareholders and bondholders would like to choose projects with high NPVs, irrespective of volatility (the NPV already factors in volatility). Of course, ex-post (once contracts are in place) equityholders will like to raise volatility (and debtholders lower it). Finally note that all we care about in an ex-post sense is the shareholders preferences, since in our anglosaxon world shareholders are the only ones with control rights (one may thing about this twice in Germany or Japan). Therefore, in ex-ante terms, I would expect both equityholders and debtholders to prefer the B-flat major project (over the B-flat minor project). Moreover, I would not expect ex-post conflicts - the B-flat major project is preferred by equityholders due to its higher risk as well.
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