When 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 statement is true. The value of the equity in a firm with risky debt can be viewed as an option on the total value of the firm, with the exercise price equal to the face value of the debt. This is because the value of the equity is contingent on the value of the firm above and beyond the value required to pay off the debt. If the firm's value is not high enough to cover the face value of the debt, the equity is worthless, just like a call option with a high exercise price. However, if the firm's value exceeds the face value of the debt, the equity provides a leveraged upside for the shareholders, similar to the value of an in-the-money call option.

When a Firm Has Risky Debt, Its Equity Can Be