Question

ABC Corporation has issued debt with $10 million of principal due. In terms of viewing the equity of the firm as a call option what happens to the equity of the firm if the cash flow of the firm is greater than $10 million？

A:The option is out-of-the-money, the stockholders walk away, and the bondholders receive the entire cash flow
B:The option is in-the-money and the stockholders earn the difference between the cash flow and the bondholder's promised payment
C:The option is out-of-the-money and the stockholders make up the difference so hat the bondholders receive full payment
D:The option is at-the-money, stockholders are indifferent about exercising the option as the bondholders standby
E: The option is in-the-money and the bondholders earn the entire cash flow

Answer 1

Assumption: Equity is to be treated as a Call Opotion

Debt Principal: USD 10 million

If the Cash Flow > USD 10 million

So if the Cash Flow exceeds 10 million, it exceeds the Debt Outstanding:

Cash Flow > Debt , Assets > Net Debt

If the Assets are greater than Net Debt , then the Equity position is positive , which mean the Equity holders can walk away with the money after repayment of the Debt (since Cash is sufficient to do that).

Hence B) is the correct option.