In relating stockholder value in terms of put options, the stockholders own the firm, they owe promised payments to the bondholders, and they have bought a put on the firm's assets with an exercise price equal to the promised payment to the bondholders. If the firm's cash flow is greater than these promised payments:
A) the put is out-of-the-money, is not exercised, and the stockholders retain ownership.
B) the put is out-of-the-money, is exercised, and the stockholders retain ownership.
C) the put is in-the-money, is exercised, and the stockholders walk away from their promise to the bondholders.
D) the put is in-the-money, is exercised, and the stockholders retain ownership.

Question

Quizplus · Accepted Answer

When the firm's cash flow exceeds the promised payments to bondholders, the put option (representing the option to default on debt) is out-of-the-money because the firm's assets are worth more than the debt. Therefore, there is no incentive to exercise the option, and stockholders retain ownership of the firm.

In Relating Stockholder Value in Terms of Put Options, the Stockholders