Increasing Risk Can Increase Equity Value
In traditional discounted cash flow valuation, higher risk
almostalwaystranslatesintolowervalueforequityinvestors.
Butwhenequitytakesonthecharacteristicsofacalloption,
weshould not expectthis relationshipto continueto hold.
Riskcanbecomeourallywhenweareequityinvestorsina
troubledfirm.Inessence,wehavelittletoloseandmuchto
gain from swings in firm value.
ILLUSTRATION 17.10: Equity Value and Volatility
LetusrevisitthevaluationinIllustration17.8.Thevalueof
theequityisafunctionofthevarianceinfirmvalue,which
weassumedtobe40%.Ifwechangethisvariance,holding
all else constant, the value of the equity will change as
evidenced in Figure 17.3. Note that the value of equity
increases, if we hold firm value constant, as the standard
deviationincreases.Theinterestrateondebtalsoincreasesas
the standard deviation increases.