We suggest a methodology for valuing corporate securities that allows the straightforward derivation of closed form solutions for complex capital structure scenarios. The tractability of the approach stems from its modularity – we provide a number of intuitive building blocks that are sufficient for valuation in most typical situations. A further advantage of our approach is that it makes economic interpretation far easier than what is typically possible with other approaches such as solving partial differential equations. As examples we consider a corporate coupon bond with discrete payments and debt subject to strategic debt service.
Introduction: With the Black & Scholes (1973) model, a versatile methodology for the val-uation of corporate securities was made available. Their insight was that the payo¤s to many instruments on the firms balance sheet were analogous to those of options. Thus the stock option pricing formula they derived could also be used to price corporate liabilities. The aim of this paper is to show that some simple ideas related to barrier contracts can be applied to relatively complex scenarios and that closed form expressions for the relevant corporate securities can be obtained with consider-able ease. The framework we suggest is flexible enough to accommodate such exigencies as bankruptcy costs, corporate taxes and deviations from the abso- lute priority rule. Besides ease of implementation, an important advantage of our approach is its transparency. It is more straightforward to interpret com-ponents of the derived formulae than if, for example, they had been obtained as solutions to partial di¤erential equations.
Author: Jan Ericsson and Joel Reneby
Source: Stockholm School of Economics
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