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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

Author

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  • Marc Chesney

    (GREGH - Groupement de Recherche et d'Etudes en Gestion à HEC - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique)

  • Rajna 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 which and quantifies the asset substitution problem previously acknowledged by the agency literature.

Suggested Citation

  • Marc Chesney & Rajna Gibson-Asner, 1999. "The Investment Policy and the Pricing of Equity in a Levered Firm: a Re-Examination of the "Contingent Claims" Valuation Approach," Working Papers hal-00601496, HAL.
    • Handle: RePEc:hal:wpaper:hal-00601496
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    Cited by:

    1. Reisz, Alexander S. & Perlich, Claudia, 2007. "A market-based framework for bankruptcy prediction," Journal of Financial Stability, Elsevier, vol. 3(2), pages 85-131, July.

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