Option Pricing Model For Firm Valuation

The principle is that if you buy a company then it is like buying a call option – if the company does well and the value increases then you get the benefit of the increase. However if the company does badly, then the most you can lose is the amount you originally paid.

(Just as with buying an ordinary option on a share – if the value of the share increases then you exercise the option and get the benefit. However if the value falls, you just throw away your option. All you have lost is the premium that you paid for the option).

So we value the company in the same way as we would calculate the premium on a call option, using the Black Scholes formula.

To go into more detail would mean writing a full article, which I cannot do on here. However, if you look at the answer to part (b) of question 2 in the June 2010 exam, it does explain pretty well how we get Pa and Pe etc for the formula.

I think the current examiner has indicated that he would not be testing this topic through calculations. If that’s correct then John’s explanation is sufficient for any discussion element that could come up.