Question

Q:

Express the position of a debt holder in terms of put options, and use option theory to explain the debt-overhang problem, or, how managers could decide to forgo projects with positive NPVs when the firm has a high level of financial leverage.

Answer 1

A iput ioption iis ia icontract ithat iallows ian iinvestor ithe iright ibut inot ithe iobligation ito isell ishares iof ian iunderlying isecurity iat ia icertain iprice iat ia icertain itime. iUnlike ia icall ioption, ia iput ioption iis itypically ia ibearish ibet ion ithe imarket, imeaning ithat iit iprofits iwhen ithe iprice iof ian iunderlying isecurity igoes idown.

i i i i i i i i i i i i i i i i i iOptions itrading iis ioften iused iin iplace iof iowning istocks ithemselves. iFor iexample, iif iyou iwere ibearish ion ia iparticular istock iand ithought iits ishare iprice iwould idecrease iin ia icertain iamount iof itime, iyou imight ibuy ia iput ioption iwhich iwould iallow iyou ito isell ishares i(generally i100 iper icontract) iat ia icertain iprice iby ia icertain itime. iThe iprice iat iwhich iyou iagree ito isell ithe ishares iis icalled ithe istrike iprice, iwhile ithe iamount iyou ipay ifor ithe iactual ioption icontract iis icalled ithe ipremium. iThe ipremium iessentially ioperates ilike iinsurance iand iwill ibe ihigher ior ilower idepending ion ithe iintrinsic ior iextrinsic ivalue iof ithe icontract.

i i i i i i i i i i i i i i i i i i i i iWhen iyou're ibuying ia iput ioption, iyou iare i"putting" ithe iobligation ito ibuy ithe ishares iof ia isecurity iyou're iselling iwith iyour iput ion ithe iother iparty iat ithe istrike iprice i- inot ithe imarket iprice iof ithe isecurity. iWhen itrading iput ioptions, ithe iinvestor iis iessentially ibetting ithat, iat ithe itime iof ithe iexpiration iof itheir icontract, ithe iprice iof ithe iunderlying iasset i(be iit ia istock, icommodity ior ieven iETF) iwill igo idown, ithereby igiving ithe iinvestor ithe iopportunity ito isell ishares iof ithat isecurity iat ia ihigher iprice ithan ithe imarket ivalue i- iearning ithem ia iprofit.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iif ithe iNPV iis ipositive, ithe iproject ishould ithen ibe ifinanced iin iaccordance iwith ithe itarget icapital istructure. iBoth iinvestors iand icompanies iemploy ileverage i(borrowed icapital) iwhen iattempting ito igenerate igreater ireturns ion itheir iassets. iHowever, iusing ileverage idoes inot iguarantee isuccess, iand ipossible iexcessive ilosses iare imore ilikely ifrom ihighly ileveraged ipositions.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iFinancial ileverage iarises iwhen ia ifirm idecides ito ifinance ithe imajority iof iits iassets iby itaking ion idebt. iFirms ido ithis iwhen ithey iare iunable ito iraise ienough icapital iby iissuing ishares iin ithe imarket ito imeet itheir ibusiness ineeds. iIf ia ifirm ineeds icapital, iit iwill iseek iloans, ilines iof icredit, iand iother ifinancing ioptions.

When ia ifirm itakes ion idebt, ithat idebt ibecomes ia iliability ion iits ibooks, iand ithe icompany imust ipay iinterest ion ithat idebt. iA icompany iwill ionly itake ion isignificant iamounts iof idebt iwhen iit ibelieves ithat ireturn ion iassets i(ROA) iwill ibe ihigher ithan ithe iinterest ion ithe iloan.

i i i i i i i i i i i i iNet ipresent ivalue i(NPV) iis ithe idifference ibetween ithe ipresent ivalue iof icash iinflows iand ithe ipresent ivalue iof icash ioutflows iover ia iperiod iof itime. iNPV iis iused iin icapital ibudgeting iand iinvestment iplanning ito ianalyze ithe iprofitability iof ia iprojected iinvestment ior iproject.

i i i i i i i i i i i i i i i i iA ipositive inet ipresent ivalue iindicates ithat ithe iprojected iearnings igenerated iby ia iproject ior iinvestment i- iin ipresent idollars iexceed ithe ianticipated icosts, ialso iin ipresent idollars. iIt iis iassumed ithat ian iinvestment iwith ia ipositive iNPV iwill ibe iprofitable, iand ian iinvestment iwith ia inegative iNPV iwill iresult iin ia inet iloss. iThis iconcept iis ithe ibasis ifor ithe iNet iPresent iValue iRule, iwhich idictates ithat ionly iinvestments iwith ipositive iNPV ivalues ishould ibe iconsidered.

i i i i i i i i i i i i i i i i i i i i i i i iA icompany ineeds ifinancial icapital ito ioperate iits ibusiness. iFor imost icompanies, ifinancial icapital iis iraised iby iissuing idebt isecurities iand iby iselling icommon istock. iThe iamount iof idebt iand iequity ithat imakes iup ia icompany’s icapital istructure ihas imany irisk iand ireturn iimplications. iTherefore, icorporate imanagement imust iuse ia ithorough iand iprudent iprocess ifor iestablishing ia icompany’s itarget icapital istructure. iThe icapital istructure iis ihow ia ifirm ifinances iits ioperations iand igrowth iby iusing idifferent isources iof ifunds.

i i i i i i i i i i i i i i i iFinancial ileverage iis ithe iextent ito iwhich ifixed-income isecurities iand ipreferred istock iare iused iin ia icompany’s icapital istructure. iThe iuse iof ifinancial ileverage ialso ihas ivalue iwhen ithe iassets ithat iare ipurchased iwith ithe idebt icapital iearn imore ithan ithe icost iof ithe idebt ithat iwas iused ito ifinance ithem. iUnder iboth iof ithese icircumstances, ithe iuse iof ifinancial ileverage iincreases ithe icompany’s iprofits.