Question

Explain the logic underpinning the assertion in Merton’s model that the equity holders of an indebted firm can be considered as having a call option on the assets of the firm, with an exercise price equal to the face value of the debt.

Answer 1

In the call option, it is very important to understand that only when the stock price at maturity is above the exercise price then only the investor with a call option will exercise the contract otherwise will let the contract expire.

As per the merton's model, the equity holders are having a call option on the assets of the firm with an exercise price equal to the face value of the debt. Think it of as pure contract in call option, now equity holders are the owners of the company and in case if the company gets liquidated then debt will be paid first and equity will get their amount later on from remaining amount.

Now in this case, equity holders will receive more if the amount realized from sale of assets of the company is more than debt payable by the company. It mostly resembles with the situation when stock price at maturity is more than exercise price. Therefore, equity holders will get amount in case of liquidation only in case when the realized amount from sale of assets is more than debt payable by the company.

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