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Suppose there is a large probability that L will default on its debt. For the purpose of this example, assume that the value of L's operations is $4...
Suppose there is a large probability that L will default on its debt. For the purpose of this example, assume that the value of L's operations is $4 million (the value of its
debt plus equity). Assume also that its debt consists of 1-year, zero coupon bondswith a face value of $2 million. Finally, assume that L's volatility, σ, is 0.60 and that the
risk-free rate is 6%. What is the value of L's stock for volatilities between 0.20 and 0.95? What incentives might the manager of L have if she understands this relationship? What might debtholders do in response?
