When a firm in financial distress accepts very risky projects, the stockholders benefit at the expense of the bondholders. In terms of option theory, the gain to the stockholders occurs because:
A) the stock is a put option on the firm's assets, and risky projects decrease the exercise price of the option.
B) the stock is a put option on the firm's assets, and risky projects increase the exercise price of the option.
C) the stock is a call option on the firm's assets, and risky projects increase the volatility of those assets.
D) the stock is a call option on the firm's assets, and risky projects decrease the volatility of those assets.

Question

Quizplus · Accepted Answer

The stock can be viewed as a call option on the firm's assets, where the exercise price is the value of the debt. Risky projects increase the volatility of the firm's assets, which increases the value of the call option (stock), benefiting stockholders.

When a Firm in Financial Distress Accepts Very Risky Projects