A firm has a market value of $10 million and outstanding debt of $6 million that matures in 5 years. The firm asset grows at a rate of 15% with a standard deviation of 30%, and the risk-free rate is 5% with continuous compounding. (a) What is the fair value of the equity? (b) Express the market value of the debt as a function of a put option on the firm’s asset. (c) If the risk-free rate is 10% and everything else is unchanged, will the market value of equity and the market value of debt be changed? How?
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