FRM II-CR 3

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FRM II-CR 3

In the Merton model, with only debt and equity in the capital structure, the value of debt will decrease and the
value of equity will increase if the:
I. interest rate increases.
II. volatility of firm value increases.
III. value of the firm increases.
IV. value of the firm decreases.
A) II and III.
B) I, II, and IV.
C) I only.
D) I and II.
Statements I and II are true. An increase in interest rates or volatility would increase the value of equity because
equity is valued as a call option. Since the value of the firm is assumed to be constant the value of debt must
decrease. Statements III and IV are incorrect because of the direct relationship between both equity and debt values and firm value.
Can you explain little more clearly why 3 & 4 is incorrect.. also what is the impact on value of debt regarding 3&4

edupristine
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FRM II-CR 3

In the Merton model, the value of the equity is directly related to the value of firm. Interest rate and volatility of the firm are directly related to the value of equity. So, if the interest rates and volatility of the firm value increases, the equity value will increase. Correspondingly, debt value would decrease to keep the firm value constant. Therefore statements I &II are correct.

However, if the value of firm increases or decreases, we can't estimate with certainty if the value of debt/equity has increased/decreased. Hence statements III & IV are incorrect.

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Great explaination

anbu.edu
Finance Junkie
Posts: 205
Joined: Mon Feb 04, 2013 3:35 pm
In the Merton model, with only debt and equity in the capital structure, the value of debt will increase in value if
the:
I. interest rate declines.
II. volatility of firm value increases.
III. value of the firm increases.
IV. volatility of firm value decreases.
A) I only.
B) I, III, and IV only.
C) III and IV only.
D) I and II only.
Statements I, III, and IV are correct. In the Merton model, the value of debt is directly related to the value of the
firm and the principal amount. Time to maturity of the debt claim, interest rate, and the volatility of the firm are all
inversely related to the value of debt.

This is a similar question but the answer is different.. Can you please explain why 3 is correct answer