Dada Adefolami

It was only when the threat of nationalization became a live issue in the last months of 2008 that the equity value started to collapse, and this again is easily explained within the BSM framework. Nationalization has the effect of eliminating the chance of asset recovery for the shareholders, effectively depriving them of the time value of their call option on the underlying assets of the business.

What is the rationale for this rather odd result – that the equity of a business can still have substantial positive value even though the balance sheet shows a nil balance on a fair value basis? The answer is that the presence of limited liability protects the investors from loss, and indeed they have everything to gain if the asset values should recover. This leads to another inescapable conclusion: when a company is near the money, i.e. when its level of gearing approaches 100%, the equity investors will become more and more risk aggressive. Simple agency arguments suggest that they will incentivize management to take risk rather than reduce it – and hence the very high levels of rewards paid to bank staff and particularly to those in the risk-taking part of the business. 

Finally
The insights of the work of Black, Scholes and Merton provide us with a framework for the valuation of companies that are financed, in part, by borrowing. Where shareholders are protected by limited liability, the shareholders have a call option on the underlying assets of the business. Using the BSM model, we can estimate the value of a firm’s equity on the basis of the value of its assets and their volatility. For companies that are deep in the money then their time value will be small and the intrinsic value of the business i.e. the present value of its assets less its liabilities will dominate the value of its equity. In this situation, normal risk aversion is expected to apply as the intrinsic value will be equally exposed to both positive and negative movements in the values of the firm’s assets.

The situation changes dramatically when we have companies that are near the money. This can occur with high growth start-ups financed by debt, leveraged buyouts, and indeed companies that are moving the other way and are in risk of default.

However, one class of company – banks – always operates near the money. In valuing such businesses, time value will be more important than intrinsic value in setting the value of the firm’s equity.Also learn that when time value dominates investors become risk aggressive, as the more risk that is taken on by management the greater the value of their equity. As a result a bank will incentivize its management to take risk, and will also reward management who can push the bank closer and closer to the money by expanding its assets and liabilities without increasing its capital.

A lender may impose certain covenants as part of a debt agreement, such as a requirement that a current ratio of at least 2:1 be maintained, or that no dividends be paid as long as the debt is outstanding. If the borrower breaches a covenant, the lender is permitted to call the loan, thereby forcing its immediate repayment by the borrower

An amount owed to a person or organization for funds borrowed. Debt can be represented by a loan note, bond, mortgage or other form stating repayment terms and, if applicable, interest requirements. These different forms all imply intent to pay back an amount owed by a specific date, which is set forth in the repayment terms.

Debt instruments are assets that require a fixed payment to the holder, usually with interest. Examples of debt instruments include bonds (government or corporate) and mortgages. The equity market often referred to as the stock market is the market for trading equity instruments.

Dada Suraju Adefolami, Professor of Finance, School of Business Administration, UNEM University Costa Rica, is a Finance / Management Consultant and Certified Forensic Accountant. You can reach him via: [email protected]; 08052043855