Managerial Discretion and the Contingent Valuation of Corporate Securities

Abstract

Modigliani and Miller argued that one must consider an entire firm as a primary asset and the stock and bonds it issues only derivatives on that asset. This line of reasoning leads to valuation of corporate securities as contingent claims, with the equity holders' option to declare bankruptcy and default on the debt providing an importance source of value to the shareholders. However, empirical evidence typically finds that stock prices are higher than the contingent valuation model would suggest. Garbade argues that management has a great variety of strategic options that it may exercise on behalf of the shareholders, and such studies do not fully take them into account. Valuing these options precisely may well be beyond our capabilities, although they can be easily seen in specific examples. Such “strategic options” can help to explain why some callable bonds are called “early” or “late,” and how management may use dividend payouts to transfer value from bondholders to equity holders. A general principle that emerges is that strategic options are exercisable for the benefit of the stockholders, so that failing to fully take account of them will cause contingent valuation models to underprice a firm's stock and overprice its bonds.