In an extension of the Merton model, a very highly geared company has two tiers of debt, a senior debt and a junior debt. Both consist of zero coupon…

In an extension of the Merton model, a very highly geared company has two tiers of

debt, a senior debt and a junior debt. Both consist of zero coupon bonds payable in

three years time. The senior debt is paid before the junior debt.

Let F

t be the value of the company at time t, L1 the nominal of the senior debt and L2

the nominal of the junior debt.

(i) (a) State the value of the senior debt at maturity.

(b) Deduce the value of the junior debt at maturity

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