4.Thevalueofthefirmandthevarianceinthatvaluecanbe
estimated.
Each ofthese assumptions ismade for a reason. First, by
restrictingtheclaimholderstojustdebtandequity,wemake
theproblemmoretractable;introducingotherclaimholders
suchaspreferredstockmakesitmoredifficulttoarriveata
result,albeitnotimpossible.Second,byassumingonlyone
zerocoupondebtissuethatcanberetiredatfacevalueatany
timepriortomaturity,wealignthefeaturesofthedebtmore
closelytothefeaturesofthestrikepriceonastandardoption.
Third,ifthedebtiscoupondebt,ormorethanonedebtissue
isoutstanding,theequityinvestorscanbeforcedtoexercise
(liquidatethefirm)attheseearliercoupondatesiftheydonot
have the cash flows to meet their coupon obligations.
Fourth,knowingthevalueofthefirmandthevarianceinthat
valuemakestheoptionpricingpossible,butitalsoraisesan
interestingquestionabouttheusefulnessofoptionpricingin
equityvaluation.Ifthebondsofthefirmarepubliclytraded,
themarketvalueofthedebtcanbesubtractedfromthevalue
ofthefirmtoobtainthevalueofequitymuchmoredirectly.
The option pricing approach does have its advantages,
however.Specifically,whenthedebtofafirmisnotpublicly
traded,optionpricingtheorycanprovideanestimateofvalue
forthe equityin thefirm.Evenwhen thedebtispublicly
traded,thebondsmaynotbecorrectlyvaluedandtheoption
pricingframeworkcanbeusefulinevaluatingthevaluesof
debtandequity.Finally,relatingthevaluesofdebtandequity
tothevarianceinfirmvalueprovidessomeinsightintothe
redistributive effects of actions taken by the firm.
Inputs for Valuing Equity as an Option