Valuing Corporate Securities: Some Effects of Bond Indenture Provisions

Abstract

PAPER Black and Scholes [3] presented an explicit equilibrium model for valuing options.In this paper they indicated that a similar analysis could potentially be applied to all corporate securities.In other papers, both Merton [8] and Ross [11] noted the broad applicability of option pricing arguments.At the same time Black and Scholes also pointed out that actual security indentures have a variety of conditions that would bring new features and complications into the valuation process.Our objective in this paper is to make some general statements on this valuation process and then turn to an analysis of certain types of bond indenture provisions which are often found in practice.Specifically, we will look at the effects of safety covenants, subordination arrangements, and restrictions on the financing of interest and dividend payments.Throughout the paper we will make the following assumptions: al) Every individual acts as if he can buy or sell as much of any security as he wishes without affecting the market price.a2) There exists a riskless asset paying a known constant interest rate r.a3) Individuals may take short positions in any security, including the riskless asset, and receive the proceeds of the sale.Restitution is required for payouts made to securities held short.a4) Trading takes place continuously.a5) There are no taxes, indivisibilities, bankruptcy costs, transaction costs, or agency costs.a6) The value of the firm follows a diffusion process with instantaneous variance proportional to the square of the value.This last assumption is quite important and needs some amplification.Until very recently this was the standard framework for discussions of contingent claim pricing.Increasing evidence, however, indicates that it may not be completely.appropriate.'The instantaneous variance may be some other function of the firm