This preview shows page 1. Sign up to view the full content.
Unformatted text preview: Equity as an Option
Before you make the mistake of thinking we are only talking about the kind of
options traded at the CBOE, let us use option theory to gain some insights in
valuing equity. We now treat all share owners as one, and look at the total value
of the equity in a company. The equity in a ﬁrm can in fact be interpreted as a
call option on the assets of the ﬁrm!
Consider the simpliﬁed balance sheet of a ﬁrm, where all numbers are in
market values. Today’s balance sheet looks like this:
Assets ( ) Debt
Equity is the value of the assets;
is the current value of debt;
is the value of
equity. Assuming the debt expires tomorrow, and debt obligations amount to ,
the tomorrow’s balance sheet is as follows (primes denote tomorrow’s values):
Assets ( ) Debt (
Equity ( )
) Notice that tomorrow’s value of equity (which we will denote
) is like the
payoﬀ on a call option: as long as tomorrow’s value of the assets ( ) is larger
than debt obligations ( ), shareholders have a residual claim; if it is not, they
receive nothing...
View Full
Document
 Fall '08
 Lehmann,B

Click to edit the document details