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a. Define Equity as "a call option". Give a brief explanation.

a. Define Equity as "a call option".
Give a brief explanation.

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Answer #1

Equity is considered to be a call option on the assets of the company with a strike price equal to the value of debt.

If the value of the assets upon liquidation is greater than the value of debt, then the shareholders have a claim over the assets beyond the value of the debt.

If the value of the assets upon liquidation is lower than the value of debt, then the shareholders get nothing. This is similar to a call option which is worthless.

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