# Equity as call option. The effect on equity value of simultaneously reducing firm value by x and increasing firm variance by y is illustrated by the change in the call price from the first scenario to the second scenario. We will fix T= and r=, and calculate the option value under each scenario for a range of strike prices. • As the strike price.

## Equity as call option. The effect on equity value of simultaneously reducing firm value by x and increasing firm variance by y is illustrated by the change in the call price from the first scenario to the second scenario. We will fix T= and r=, and calculate the option value under each scenario for a range of strike prices. • As the strike price.

Sometimes, investing in special read: Rather than soberly evaluating the business's strengths, weaknesses, and opportunities, and assessing its industry positioning -- all of which are important! Dusty finance textbooks define a company's equity stock as a residual claim against the firm.

This is just a fancy way of saying that shareholders are low on the totem pole if company firmly and finally takes a dirt nap.

Debt providers and other claimants get satisfied first, and stockholders get the leftover scraps usually zilch. There's no better example than the airline industry. It requires big investments usually lease or debt financing -- planes are expensive.

It's subject to cutthroat competition. And its inventory available seats spoils every time a plane lifts off half-empty. But if you can find a high-quality distressed company an oxymoron, perhaps?

Equity as call option Discounted cash flow models and relative valuation techniques are generally useless when applied to distressed firms. This sort of analysis only reinforces that the company is in trouble.

Instead, investors should view the company's equity as either fading to black, or paying off big as its managers right their ship. For such an occasion, we can use an option-pricing model to value the firm's equity. We consider the time-to-maturity of the debt as the option's life, and the value of the debt as the de-facto "strike price" of the option.

After all, if things didn't go well, the bondholders will end up owning the company. BLT , which makes chainsaw chain, guide-bars, and timber-harvesting equipment for the forestry and construction industries. It manufactures for nearly every major forestry toolmaker, and markets its own product line as well. It's a boring business with a dominant position. Does that sound promising? Recapitalization for no fun and profit In mid, Blount was on the sales block. Following recapitalization, Blount sought to "right-size" the company with the scale of its interest payments.

Its private aircraft was sold in In December , still flirting with debt covenant noncompliance, Blount sold its sporting-equipment segment, which produced small-arms ammunition, optical products, and other sport-shooting accessories, to Alliant Techsystems NYSE: In , its former corporate headquarters in Alabama was shuttered, and corporate functions were amalgamated with the head office for the largest remaining business segment in Portland, Ore.

How bad did it get? By , the company couldn't afford to pay the interest it owed and still invest in its business:. Was I unaware of the dire financials? Did I not recognize the default potential, followed by the sweet embrace of bankruptcy? Of course, dear Fool! But I also saw a thriving business and a supermajority shareholder with a vested interest in seeing the share price turn around.

Also, consider that financials higher up the income statement remained stable, and that the debt was not due for some years. In other words, yes, debt was a problem. Presuming the company avoided bankruptcy, there was little more that could happen to Blount's stock price, and even a little good news could see a potentially outstanding outcome. As things marginally improved, so did the equity value. The Foolish bottom line Our story has a happy ending. Blount managed a halfway decent though not spectacular turnaround.

Sometimes, merely changing the way we look at investments can open up a world of new possibilities. Do you consider yourself a special-situations investor, or are you interested in learning more about these opportunities? Tell us about your interests in our very brief Special Situations Investing Survey. Your comments will help us develop future content to fit your needs.

Jim Gillies , a member of the Hidden Gems team, often looks at things from a unique perspective. Maybe tat's why he loves a good special situation.

To find out why our Hidden Gems newsletter is so unique, simply sign up today for a free day test drive. Jim owns no shares of any companies mentioned.

Income Investor Dividend stocks. Hidden Gems Small-cap stocks. Inside Value Undervalued stocks. View all Motley Fool Services. Learn How to Invest. Mar 30, at

More...