Buying a equity is like buying a call option on the company. True or false?
Correct Answer: True.
By understanding equity as a call option, equityholders own on a company with a strike price equal to the company's total debt.
One way to conceptualize a company's value is to think of it in terms of debtholders and equityholders. Debtholders have loaned a company money in exchange for interest payments and the eventual return of principal at a specified time. The company is indebted to debtholders and eventually must pay them back. These debtholders have a claim on the cash flows of the company.
What's left over after the company fulfills their debt obligations belongs to the equityholders. Equityholders are the owners and shareholders of a company. They own the cash flows in excess of the company's obligations. They also hold all the value of the company above and beyond what is owed to the debtholders.
An Example
Let's say XYZ Corp is a company whose stock trades publicly with both debtholders and equityholders. Today, the total value of the company is $100 million. XYZ Corp also has $75 million in face value debt set to mature in 5 years with zero coupon. Knowing there is this looming liability down the line, calculating equity isn't as simple as subtracting total debt from the total value of the company.
Equity can be thought of as a call option on the company's assets with a strike equal to the face value of the debt. This is true because of the concept of limited liability. Limited liability reduces the risk of loss for equity investors if the firm is valued less than the value of the outstanding debt.
Call Options
On liquidation of XYZ Corp, the most value that equity holders could possibly lose in XYZ Corp is equity they currently have. Limited liability protects the equityholders from having negative equity. Now draw the parallel to call options. Call options give the option holder the right to purchase value of the total debt which, in this case, equals $75 million. Since we know the debt matures in 5 years, we can also say this equity call option on the company expires in 5 years.
