For the equity of a firm to be considered a call option on the firm's assets, the firm must:
A) be in default.
B) be leveraged.
C) pay dividends.
D) have a negative cash flow from operations.
E) have a negative cash flow from assets.

Question

Quizplus · Accepted Answer

A call option gives the holder the right, but not the obligation, to buy an underlying asset at a specified price. In this case, the underlying asset is the firm's assets. The equity of a leveraged firm can be seen as a call option on the firm's assets because if the value of the assets increases, the equity holders benefit proportionately more than the debt holders. Therefore, choice B is the best answer. The other options do not apply to the concept of a call option on a firm's assets.

For the Equity of a Firm to Be Considered a Call