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ACCA Strategic Professional · Advanced Financial Management · Application of option pricing theory in investment decisions

Under the option-pricing view of a company financed by equity and a single issue of zero-coupon debt, which statement is correct?

Equity behaves like a call option on the firm's assets. The exercise price is the debt's redemption amount, because shareholders receive any surplus of asset value over the debt and nothing if assets fall short, which limits their loss.

  1. AEquity is a call option on the firm's assets with an exercise price equal to the debt's redemption amountCorrect
  2. BEquity is a put option on the firm's assets with an exercise price equal to the debt's redemption amount
  3. CDebt holders own a call option on the firm's assets and shareholders own the risk-free bond
  4. DEquity is a call option whose exercise price is the market value of the firm's assets

Explanation

Shareholders have limited liability. At maturity they receive the excess of asset value over the debt face value, or zero, which is a call payoff with the debt face value as the exercise price. Describing equity as a put reverses the payoff, because the put belongs to the lenders' side of the structure.

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