a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

Question

Quizplus · Accepted Answer

This is known as the "option analogy" and is a commonly used concept in finance. The equity holders have the right to the residual value of the firm after the debt holders have been paid off, similar to the way a call option gives the holder the right to purchase a stock at an exercise price.

A Firm Has Risky Debt, Its Equity Can Be Viewed