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lecture11post - Equity and debt options Botvinnik case...

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Equity and debt options Botvinnik case Lecture 11 - Risky debt BUSI 588, Fall 2011 Diego Garc´ ıa Kenan-Flagler Business School UNC at Chapel Hill October 3rd, 2011 c ± Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 11 - Risky debt 1 / 22
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Equity and debt options Botvinnik case Outline 1 Equity and debt options Equity as a call Senior and junior debt Implications An example 2 Botvinnik case Financing SI Financing SI with KI Financing KI Handouts today: Class slides. Case 11 solutions. c ± Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 11 - Risky debt 2 / 22
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Equity and debt options Botvinnik case The setting We’ll study valuation of corporate securities in some detail, in particular debt (senior and junior), equity, and convertibles. Firm has some assets which we represent (in reduced form) by their value A , which we assume to evolve randomly through time (BS assumptions). Note: A t = PV t ( FCF t + , r A ). Ignore taxes. Assume that debt has zero-coupon and finite maturity, with face value F . Easily generalizable - just draw big trees and consider default decision at each node. Tip: graphs come in handy when solving problems. c ± Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 11 - Risky debt 3 / 22
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Equity and debt options Botvinnik case The basic idea What is the option? Option to default (owned by the shareholders). Equityholders’ default option stems from legal concept of limited liability. What if the firm did not have enough cash flows, but A T > F ? Equityholders’ payoff at debt maturity is E = max( A T - F , 0) . Key insight (Black and Scholes, 1973): we can view equity as a call option where the strike price is the face value of the bond outstanding. c ± Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 11 - Risky debt 4 / 22
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Equity and debt options Botvinnik case Payoff to debt and equity Value of the firm Payoff to stakeholders at debt maturity date 0 2 04 06 08 01 0 0 0 1 02 03 05 0 E=max(A T -F,0) D=min(F, A T ) Equity defaults c ± Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 11 - Risky debt 5 / 22
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Equity and debt options Botvinnik case Senior debt Debtholders get min( A T , F ).
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This note was uploaded on 11/25/2011 for the course BUSI 588 taught by Professor Staff during the Fall '10 term at UNC.

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lecture11post - Equity and debt options Botvinnik case...

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