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

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 quot;play it safequot; while those in highly levered firms select riskier projects. The implications of the model for firms operating in reputation-sensitive business are finally examined