• Value of the firm V = 100
  • Face value of debt X is 120 and still one year to go until maturity
  • Firm value volatility is 40.5% per annum
  • Risk free rate is 6%

Consider a one-period model. If any information is not available make assumptions.

Is the equity value of the firm "in the money" or "out of the money"?

Edit: I know how to compute firm value V, return on assets rA, and value of D and E. Just don't get this question.

  • $\begingroup$ Hi GeneralLee, welcome to Quant.SE! Good that you've found the answer but this type of question is too basic here so I closed it. $\endgroup$ – Bob Jansen Oct 13 '15 at 18:28

We can value equity as a call option on the value of the firm, where exercising the option requires that the firm be liquidated and the face value of the debt (which corresponds to the exercise price) paid off.

The parameters of equity as a call option are as follows:

  • Value of the underlying asset = S = Value of the firm = 100
  • Exercise price/Strike price = K = Face Value of outstanding debt = 120

A call option is in the money, when the strike price is below the market price of the underlying asset. A call option is out of the money, when K > S.

S = 100 and K = 120; K > S, so the equity value of the firm is out of the money.

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