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6、The Merton model is:

A) a structural model and a value-based model.

B) a structural model but not a value-based model.

C) a value-based model but not a structural model.

D) neither a structural model nor a value-based model.

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The correct answer is A

The Merton model is considered both a value-based model and a structural model.

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7、In the Merton model, with only debt and equity in the capital structure, the value of equity will increase in value if the:

      I. interest rate increases.

     II. volatility of firm value increases.

    III. value of the firm decreases.

    IV. face value of debt increases.

A) I and II.

B) I only.

C) I, II, and IV.

D) III and IV.

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The correct answer is A

Statements I and II are correct. In the Merton model, the value of equity is directly related to the value of the firm and the principal amount. Interest rate and the volatility of the firm are directly related to the value of equity.

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8、Using the Merton model to value the firm’s debt and equity, which of the following scenarios is NOT possible? Assume the other three are true.

I.           Equity = 0; Debt = $20.

II.         Equity = $10; Debt = $35.

III.        Equity = $10; Debt = $20.

IV.      Equity = 0; Debt = $35.

A) III only.

B) II only.

C) I only.

D) IV only.

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The correct answer is A

Equity cannot have a positive value until debt has reached its face value of $35.

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10、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) III and IV only.

C) I, III, and IV only.

D) I and II only.

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The correct answer is C

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.

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AIM 5: Explain how interest rate dynamics and the interaction with firm value affect the price of debt.

Suppose a levered firm (with only one debt issue) is experiencing financial distress and that the firm’s value of debt is affected by unanticipated changes in interest rates. Which of the following statements is/are consistent with the models that include variables that measure interest rate dynamics?

 I. The value of debt will increase if the volatility of interest rates declines.

 II. The value of debt will increase if the correlation between the firm value and changes in interest rates increases.

 III. The value of debt will increase if the speed of mean reversion of interest rates increases.

 IV. The value of debt will increase if the long-term mean increases.

A) I and III.

B) I and IV.

C) II and IV.

D) I and II.

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The correct answer is B

Statements I and IV are true. In the Shimko, Tejima, and van Deventer (1993) model, an increase in the volatility of interest rates will result in lower values for debt and higher values for equity; therefore, statement I is true. Likewise, a higher correlation between firm values and changes in interest rates will result in lower debt values and higher values for equity; therefore, statement II is false. The Vasicek model includes a speed to reversion term that is also included in the model presented by Shimko, Tejima, and van Deventer. In this model, a higher value for the speed term reduces the value of debt and a increases the value of equity; therefore, statement III is false. The long-term mean in the Shimko, Tejima and van Deventer model is directly related to debt values and inversely related to equity values; therefore, statement IV is true.