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The investment policy and the pricing of equity in a levered firm: a re-examination of the 'contingent claims' valuation approach

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  • M. Chesney
  • R. Gibson-Asner
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    Abstract

    In this study we re-examine the pricing of equity and the risk incentives of shareholders in levered firms. We derive a down-and-out call equity valuation model which rests on the assumption that shareholders choose the optimal investment and asset returns' volatility as a function of current leverage. Contrarily to the Black and Scholes framework where, irrespective of the firm's leverage, they would always select infinite volatility projects, here the more deep out-of-the-money the shareholders' claim, the greater their incentives to select riskier investment projects. The model is thus consistent with and quantifies the asset substitution problem previously acknowledged by the agency literature.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/135184799337118
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    Bibliographic Info

    Article provided by Taylor and Francis Journals in its journal The European Journal of Finance.

    Volume (Year): 5 (1999)
    Issue (Month): 2 ()
    Pages: 95-107
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    Handle: RePEc:taf:eurjfi:v:5:y:1999:i:2:p:95-107

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    For corrections or technical questions regarding this item, or to correct its listing, contact: (Michael McNulty).

    Related research

    Keywords: Agency Problems; Asset Substitution; Contingent Claim; Down-and-out Call Option; Capital Structure; Leverage; Risk Incentives;

    References

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    1. Galai, Dan & Masulis, Ronald W., 1976. "The option pricing model and the risk factor of stock," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 53-81.
    2. Barnea, Amir & Haugen, Robert A & Senbet, Lemma W, 1980. " A Rationale for Debt Maturity Structure and Call Provisions in the Agency Theoretic Framework," Journal of Finance, American Finance Association, vol. 35(5), pages 1223-34, December.
    3. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
    4. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
    5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    6. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
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