Session 25: Financial Flexibility and Distressed Equity as Options

We started this session, by valuing financial flexibility as an option, and arguing that it was worth more to capital-constrained companies with unpredictable and high-value-added investments. We continued with our examination of equity in trouble, debt-laden companies. Given that the equity in these companies takes on the characteristics of an option, we teased out three implications:
The equity in these companies will be valued as out-of-the-money options are and not as conventional stocks. Thus, they will retain their value, even in the face of daunting debt, and will become more valuable as the risk in the business increases and with longer term debt.
Letting equity investors in deeply distressed companies make investment decision can lead to perverse consequences: risky, negative NPV projects may be attractive to these investors, because the transfer of wealth from lenders overcomes the drop in value from the negative NPV.
Acquisitions of companies in other businesses, if not funded with additional debt or accompanied by a renegotiation of interest rates on existing debt, can make equity investors in the acquiring company worse, even if the acquisition is at fair value.
The bottom line on options: they are everywhere, most of them are worth nothing or very little and only a few can be valued with option pricing models.
Start of the class test: http://www.stern.nyu.edu/~adamodar/pd...
Slides: http://www.stern.nyu.edu/~adamodar/po...
Post class test: http://www.stern.nyu.edu/~adamodar/pd...
Post class test solution: http://www.stern.nyu.edu/~adamodar/pd...