Consider a firm with a single loan. There are no interest payments on the loan, but the principal and interest are all due in two years. It is uncertain whether the cash flow the company will produce will be enough to pay off the debt. The payoff to stockholders in this company resembles a call option.

Question

Quizplus · Accepted Answer

The payoff to stockholders in this company resembles a call option because if the cash flow generated by the company is sufficient to repay the loan, the stockholders will receive the full benefit of their investment (like a call option). However, if the cash flow falls short, the stockholders will have to surrender their investment (like an out-of-the-money call option).

Consider a Firm with a Single Loan