The value of equity within distressed firms - companies with negative earnings and high debt - can be looked at as an equity option. The option rests in the hands of equity investors, who can agree to liquidate the firm and claim the difference between firm value and debt outstanding. With limited legal liability, equity investors do not have to make up the difference if firm value drops below the value of the outstanding debt. The equity will contain value even when the value of the assets of the firm is lower than the debt outstanding, due to the time premium in the option.
Equity in Highly Levered Distressed Firms
In some publicly traded firms, equity offers two features. The first is that the equity investor controls the firm and can elect to liquidate its assets as well as pay off other claim holders anytime. The second is that the liability of equity investors in some private firms as well as nearly all publicly traded firms is limited to their equity investments in these companies. This combination of the option to liquidate and limited liability gives equity investors a call option feature. In firms with above normal debts and negative earnings, the option value of equity could be in excess of the actual discounted cash flow value.
Payoff on Equity as an Option
The equity in a firm is a residual claim, that is, equity holders lay claim to all cash flows remaining after all other financial stakeholders (debt, preferred stock, etc.) have been paid. If a firm is liquidated, the same regulations apply; equity investors get any cash left in the company after all outstanding debt and other financial claims have been settled. With limited liability, if the value of the company is lower than the value of the outstanding debt, equity investors will never lose more than their investment in the company. The payoff to equity traders on liquidation can therefore be written as:
Payoff to equity on liquidation
= V-D if V>D
= 0 if V?D
V= Liquidation value of the firm
D= Face value of the outstanding debt and other nonequity claims
Equity can then be looked at as a call option on the firm, where exercising the option requires that the company be liquidated and the face value of the debt (which corresponds to the exercise price) be paid off. The firm is the underlying assets and option expires when the debt arrives due.
Importance of Limited Liability
The debate that equity is a call option holds only when equity has limited liability - that is, the most that an equity investor can lose is what he or she has invested in a firm. This is clearly the case with publicly traded companies. In private companies, however, the owners typically accept unlimited liability. Should these private companies find their way into financial trouble and unable to make their debt payments, the owner's personal assets can be placed at risk. Do not attempt to value equity as a call option in these cases.
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