Sincethecall valuerepresentsthevalueof equityand the
firm value is $100 million, the estimated value of the
outstanding debt can be calculated.
Sincethe debtis a 10-yearzerocoupon bond, themarket
interest rate on the bond can be calculated.
Thus, the default spread on this bond should be 2.77%.
Implications of Viewing Equity as an Option
Whentheequityinafirmtakesonthecharacteristicsofacall
option,wehavetochangethewaywethinkaboutitsvalue
andwhatdeterminesitsvalue.Inthissubsection,weconsider
a numberof potentialimplicationsforequity investorsand
bondholders in the firm.
When Will Equity Be Worthless?
In discountedcash flowvaluation, wearguethat equity is
worthlessifwhatweown(thevalueofthefirm)islessthan
whatweowe.Thefirstimplicationofviewingequityasacall
optionisthatequitywillhavevalue,evenifthevalueofthe
firmfallswellbelowthefacevalueoftheoutstandingdebt.
Althoughthefirmwillbeviewedastroubledbyinvestors,
accountants,andanalysts,itsequityisnotworthless.Infact,
justasdeepout-of-the-moneytradedcalloptionscommand
value because of the possibility that the value of the