CAPITAL STRUCTURE POLICIES : Debt, equity and options theory
It seems like stating the obvious when we say that the status of the creditor differs radically from that of the shareholder. The shareholder stands to gain a potentially unlimited amount and his risk is limited to his investment, while the creditor, who can also lose his investment, can only expect a fixed return.
This asymmetry brings options to mind. This chapter showed that there is more than one similarity.
The shareholders' equity of a levered company can be seen as a call option granted by creditors to shareholders on the company's operating assets. The strike price is the value of the debt and the maturity is the date on which the debt is payable. When the debt falls due, if the value of the operating assets is higher than the amount of the debt to be repaid, the shareholders exercise their call option on the operating assets, and pay the creditors the amount of the debt outstanding. If, however, the value of the operating assets is lower than the amount of the debt to be repaid, the shareholders decline to pay off the debt, and the creditors appropriate the operating assets.
Similarly, we can show that lending to a company is a means of investing in its assets at no risk. The lender sells the shareholders a put option at a strike price that is equal to the debt to be repaid.
Using this options-based approach we can break down the value of equity into intrinsic value and time value. Intrinsic value is the difference between the present value of capital employed and the debt to be repaid upon maturity. Time value is the hope that when the debt matures, enterprise value will have risen to exceed the amount of the debt to be repaid.
This leads to a better understanding of the impact of certain decisions on the financial situation of creditors and shareholders:
- a dividend payout financed by the sale of assets will increase creditors' risk, reduce the value of the debt owed to them, and at the same time increase the value of shareholders' equity;
- investing in high-risk projects (but for which the net value at the required rate of return is nil) does not result in an immediate change in enterprise value, but increases creditors' risk, reduces the value of debt and increases the value of shareholders' equity by the same amount;
- by financing its own investments (or carrying out a capital increase), the company increases enterprise value by this amount (if the return on the investment is equal to the required rate of return). Part of this additional value will go to the creditors, whose risk is reduced, to the detriment of shareholders, as the overall value of their shares will not rise by the amount of the funds invested or the capital increase.
All financial decisions must be examined from an overall point of view, but also in terms of the creation or destruction of value for the various stakeholders. A given financial decision could be neutral in terms of overall value, but could enhance the value of some financial securities at the expense of others.