You have been asked to analyze the value of equity in a company that has the following features.
- The earnings before interest and taxes is $25 million and the corporate tax rate is 40%. There is no net capital expenditures or working capital requirements and the earnings are expected to grow 5% a year in perpetuity. The cost of capital of comparable firms is 10%.
- The firm has two types of debt outstanding – 2-year zero-coupon bonds with a face value of $250 million and bank debt with ten years to maturity with a face value of $250 million (The duration of this debt is 4 years.).
- The firm is in two businesses – food processing and auto repair. The average standard deviation in firm value for firms in food processing is 25%, whereas the standard deviation for firms in auto repair is 40%. The correlation between the businesses is 0.5.
- The riskless rate is 7%.
Use the option pricing model to value equity as an option.