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 less 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 is less than the promised payments to bondholders, the put option (representing the option to default on debt) is in-the-money. This means the value of the firm's assets is less than the exercise price (the promised payments). Stockholders can exercise this option, effectively walking away from their promise to the bondholders, as the firm defaults on its debt.

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