Applications of Option Valuation

–          The equity of a firm with debt in its capital structure is actually a call option if interest and principal are paid to creditors, shareholders own the underlying assets of the firm; if interest and principal are defaulted, creditors will end up with the assets.

–          If the S_o/X ratio is high, the option is well in the money, which implies a low proportion of debt in the company’s capital structure. If low the company has lots of debt.

–          An increase in σ means that the operating assets of the firm are more risky.

–          Specific actions taken by geared companies can shift wealth from debt holders to shareholders.