Debt and Equity Valuation of it Companies: A Real Option Approach
27 Pages Posted: 4 Dec 2004
Date Written: September 2004
We attempt in this study to estimate the fundamental equity value of a firm by combining two separate capital valuation techniques, namely the corporate debt valuation of Merton (1974) and the rational pricing technique of internet companies of Schwartz and Moon (2000). We use the Black Scholes (1973) approach proposed by Merton (1974) to infer an estimate of the value of the debt of the firm, and the pricing methodology of internet companies pioneered by Schwartz and Moon (2000) to estimate the total value of the firm. Making use of the fact that firm value is made up of debt and equity, we first derive a closed-form solution for the value of the debt and then back out implied fundamental equity values for three firms in the Information Technology sector, and show how in two cases out of three the share price is actually undervalued. We also provide inferences on the debt risk premium.
Keywords: Real options, equity, debt, Black Scholes
JEL Classification: G12, G13, G30, G32
Suggested Citation: Suggested Citation