Verma Violin Manufacturing Corporation has issued debt with $10 million of principal due. In terms of viewing the equity of the firm as a call option, what happens to the equity of the firm if the cashflow of the firm is less than $10 million?

Question

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When viewing equity as a call option, if the cash flow of the firm is less than the debt's principal ($10 million in this case), the option is considered out-of-the-money. This means the equity holders (stockholders) do not exercise their option to "buy" the firm from the bondholders, effectively walking away. The bondholders, in turn, receive the entire cash flow, even though it is less than the promised payment.

Verma Violin Manufacturing Corporation Has Issued Debt with $10 Million