The Investment Policy and the Pricing of Equity in a Levered Firm: A Reexamination of the Contingent Claims' Valuation Approach

Posted: 22 May 2000

See all articles by Marc Chesney

Marc Chesney

University of Zurich - Department of Banking and Finance

Rajna Gibson

University of Geneva - Geneva Finance Research Institute (GFRI)

Date Written: November 1994

Abstract

It is well known that shareholders in levered firms select more risky projects. Yet, Black and Scholes-Merton option pricing framework cannot explain these shareholders adverse risk incentives. Indeed, if they behave strategically they should always select infinite volatility projects. We propose a down-and-out call equity valuation model that accounts for the firm's reputation to derive the optimal volatility chosen by strategically behaving shareholders. The model shown that shareholders in weakly levered firms "play it safe" while those in highly levered firms select riskier projects. The implications of the model for firms operating in reputation-sensitive business are finally examined.

JEL Classification: G13, G32

Suggested Citation

Chesney, Marc and Gibson, Rajna, The Investment Policy and the Pricing of Equity in a Levered Firm: A Reexamination of the Contingent Claims' Valuation Approach (November 1994). Available at SSRN: https://ssrn.com/abstract=6151

Marc Chesney

University of Zurich - Department of Banking and Finance ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

HOME PAGE: http://https://www.bf.uzh.ch/en/persons/chesney-marc

Rajna Gibson (Contact Author)

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

40 Boulevard du Pont d'Arve
Geneva 4, 1211
Switzerland
+41.22.379.89.83 (Phone)

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