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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

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.

Suggested Citation

  • M. Chesney & R. Gibson-Asner, 1999. "The investment policy and the pricing of equity in a levered firm: a re-examination of the 'contingent claims' valuation approach," The European Journal of Finance, Taylor & Francis Journals, vol. 5(2), pages 95-107.
    • Handle: RePEc:taf:eurjfi:v:5:y:1999:i:2:p:95-107
    DOI: 10.1080/135184799337118
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    References listed on IDEAS

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    Cited by:

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    2. Angoua, Paul & Lai, Van Son & Soumare, Issouf, 2008. "Project risk choices under privately guaranteed debt financing," The Quarterly Review of Economics and Finance, Elsevier, vol. 48(1), pages 123-152, February.

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