We now treat all share owners as one and look at the

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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...
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