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Suppose that the current value of a companys operating assets is $100 million. The company...

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Finance

Suppose that the current value of a companys operating assets is $100 million. The company has 10-year zero-coupon debt outstanding (the only debt it has) with a principal amount at maturity of $155 million. Its debt has a yield to maturity of 10%.

(a) Draw a payoff diagram of the companys debt at maturity, as a function of the value of its assets then. Be sure to label all relevant payoffs and axes.

(b) Suppose that the government announces that the company is too big to fail, so it will fully and unconditionally guarantee the debt of the subsidiary, meaning that the government will ensure that its bonds always pay off the full amount that they owe. Draw the payoff diagram of the companys debt with the guarantee included.

(c) What is the value of the guarantee? You can assume a risk-free rate of 5%. (Hint: Calculate the value of the debt in part a, and the value of the combined debt and guarantee in part b. You can then infer the value of the guarantee based on those.)

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