Book Co. has one million shares of common equity with a par (book) value of $1 and retained earnings of $30 million, and its shares have a market value of $50 per share. It also has debt with a par value of $20 million that is trading at 101% of par.
a. What is the market value of its equity?
b. What is the market value of its debt?
c. What weights should it use in computing its WACC?
1. Was the broker correct that the protective put would prevent your uncle from taking a huge loss if the announcement caused a large decrease in the stock value? What is your uncle’s maximum possible loss per share using the protective put? What is your uncle’s maximum possible loss per share when holding Wal-Mart stock on its own? Hint: for both alternatives, examine the worst-case scenario by assuming that Wal-Mart shares become worthless and the stock price drops to zero.
2. Which strategy, the protective put or holding Wal-Mart stock on its own, provides the maximum upside potential for your uncle? Why does this occur?