Equity and debt as options

McColgan, Patrick; (2015) Equity and debt as options. In: Wiley Encyclopedia of Management. John Wiley & Sons Inc.. ISBN 9781118785317 (https://doi.org/10.1002/9781118785317.weom040007)

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This chapter explains how debt and equity contracts can be considered as options on the firm's assets. Treating interest and principal repayments on a debt instrument as the equivalent of the strike price on an option contract allows for a more detailed understanding of the payoffs to debt and equity investors conditional on future cash flows from the firm's assets. This treatment also allows for an improved understanding of the incentives of equity investors to take on financial risk by gearing up their firms in a limited liability environment for equity investors.