A firm having present market value S0=100 and face value of debt 80.

The stdev risk of firm value is 40%. T

to maturity and firm can be liquidated at any time before that time. The situation can be thought of as CAL
of the firm with strike price K=80. Assume the risk free rate as 10% per annum.
S0 (present value of firm D+E) 100 value of the firm at present since it is in con
K (present value of debt) 80 claim of debt holders, if the value of equity
T (yrs to maturity for debt) 10 any time within the maturity of the bond/d
risk free rate (p.a.) 10.00%
Volatility 40.00% calculated from the history

d1 1.5994
d2 0.3345

N(d1) 0.9451
N(d2) 0.6310

C (Option value of equity at present) 75.9430 value of equity now, as equity holders are h
Present Market value of debt 24.0570
NOTE: As we increase the time to maturity
Interest rate on debt 12.02%
 tdev risk of firm value is 40%. The debt has 10 years
uation can be thought of as CALL OPTION on EQUITY
um.
he firm at present since it is in control of equity holders
debt holders, if the value of equity drops below this, equity holders will walk away
within the maturity of the bond/debt equity holders can exercise, AMERICAN

d from the history

equity now, as equity holders are holding the option of getting the residual if positive or walking away if loss

we increase the time to maturity the firms equity value increases.

A TROUBLED firm having present market value S0=50 and face value of debt 80. The stdev risk of firm value
has 10 years to maturity and firm can be liquidated at any time before that time. The situation can be thou
OPTION on EQUITY of the firm with strike price K=80. Assume the risk free rate as 10% per annum.
S0 (present value of firm D+E) 70 value of the firm at present since it is in con
K (present value of debt) 80 claim of debt holders, if the value of equity
T (yrs to maturity for debt) 3 any time within the maturity of the bond/d
risk free rate (p.a.) 6.00%
Volatility 70.00% calculated from the history

d1 0.6445 NOTE: Equity will have a option value even

d2 -0.5679 Such a firm will be viewed as troubled by i
its equity is worthless.
N(d1) 0.7404
N(d2) 0.2851 Just as deep out-of-the-money traded opti
the underlying asset may increase above th
command value because of the time prem
C (Option value of equity at present) 32.7794 due) and the possibility that the value of th
Present Market value of debt 37.2206 they come due.
This might explain why stock in firms, that
Interest rate on debt 25.51% buyers for them
t 80. The stdev risk of firm value is 40%. The debt
time. The situation can be thought of as CALL
rate as 10% per annum.
he firm at present since it is in control of equity holders
debt holders, if the value of equity drops below this, equity holders will walk away
within the maturity of the bond/debt equity holders can exercise, AMERICAN

d from the history

uity will have a option value even if the value of firm falls below face value of outstanding debt
m will be viewed as troubled by investors, accountants and analysts, but that does not mean that
is worthless.

eep out-of-the-money traded options command value because of the possibility that the value of
rlying asset may increase above the strike price in the remaining lifetime of the option, equity will
d value because of the time premium on the option (the time until the bonds mature and come
the possibility that the value of the assets may increase above the face value of the bonds before
e due.
ht explain why stock in firms, that are essentially bankrupt, still has value, there there are some
r them
A firm having present market value S0=100 and face value of debt 80. The stdev risk of firm value is 40%. T
to maturity and firm can be liquidated at any time before that time. The situation can be thought of as CAL
of the firm with strike price K=80. Assume the risk free rate as 10% per annum. The firm stockholders want
project that has negative NPV and is highly risky. The stdev changes to 50%.
S0 (present value of firm D+E) 98 NPV value of the firm at present since it is in con
K (present value of debt) 80 -2 claim of debt holders, if the value of equity
T (yrs to maturity for debt) 10 any time within the maturity of the bond/d
risk free rate (p.a.) 10.00%
Volatility 50.00% calculated from the history

d1 1.5514 NOTE:
d2 -0.0298 The value of EQUITY increases even after t
firm becomes more risky (higher stdev) the
N(d1) 0.9396 but for a given stdev risk, with decreasing
N(d2) 0.4881 This might explain why debt holders try to

C (Option value of equity at present) 77.7144

Present Market value of debt 20.2856 77.7144
0
Interest rate on debt 13.72% -2
-4
-6
option value of equity -8
-10
1.0000 -12
0.9000
0.8000 -14
0.7000
0.6000 -16
0.5000 -18
0.4000
0.3000 -20
0.2000
0.1000 -22
-
G -24
1 3 n
5 7 m -26
9
11 lu
13 15 17 Co
19 21 23
-28
25
-30
Col umn G Col umn H Col umn I Col umn J
Col umn K Col umn L Col umn M
-32
-34
-36
-38
-40
-42
-44
-46
-48
-50
 tdev risk of firm value is 40%. The debt has 10 years
uation can be thought of as CALL OPTION on EQUITY
um. The firm stockholders want to engage in a

he firm at present since it is in control of equity holders

debt holders, if the value of equity drops below this, equity holders will walk away
within the maturity of the bond/debt equity holders can exercise, AMERICAN

d from the history

e of EQUITY increases even after taing a very risky project with negative NPV (risk taking) and if the
omes more risky (higher stdev) the option value of equity rises further.
given stdev risk, with decreasing NPV of new vantures, firms option value of equity falls.
ht explain why debt holders try to have restrictions covenants.

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