Valuation Of Equity And Debt In A Leveraged Firm

In our earlier chapter on options, we pointed out that the equity in a leveraged corporation (i.e., a corporation that has borrowed money) can be viewed as a call option on the assets of the business. The reason is that, when a debt comes due, the stockholders have the option to pay off the debt, and thereby acquire the assets free and clear, or else default. The act of paying off the debt amounts to exercising an in-the-money call option

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VIII. Topics in Corporate Finance

24. Option Valuation

© The McGraw-Hill Companies, 2002

PART EIGHT Topics in Corporate Finance

Work the Web

From our discussion of implied standard deviations (ISDs), you know that solving for an ISD when you know the option price is simply trial and error. Fortunately, most option calculators will do the work for you. To illustrate, suppose you have a call option with a strike price of $90 that matures in 62 days. The stock currently sells for $87.10, the option sells for $5.80, and the interest rate is 4.5 percent per year, compounded continuously. What is the ISD? To find out, we went to the options calculator at www.numa.com. After entering all this information, here is what we got:

implied volatility for european call option

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