Thomas S. Y. Ho and Sang Bin Lee
Volume 2, Number 2, Second Quarter 2004
This paper proposes a valuation model of a bond with default risk. Extending from the Brennan and Schwartz real option model of a firm, the paper treats the firm as a contingent claim on the business risk. This paper introduces the “primitive firm,” which enables us to value firms with operating leverage relative to a firm without operating leverage. This paper emphasizes the business model of the firm, relating the business risk to the firm’s uncertain cash flow and its assets and liabilities. In so doing, the model can relate the financial statements to the risk and the value of the firm. The paper then uses Merton’s structural model approach to determine the bond value. This model considers the fixed operating costs as payments of a “perpetual debt,” and the financial debt obligations are junior to the operating costs. Using the structural model framework, we relative value the bond to the observed firm’s market capitalization, and provide a model that is empirically testable. We also show that this approach can better explain some of the high yield bond behavior. In sum, this model extends the valuation of high yield bonds to incorporate the business models of the firms and endogenizes the firm value stochastic process, which is a key element in high yield valuation, in practice.We have shown that in relating the firm’s business model to the firm value, the resulting firm value stochastic process affects the bond value significantly.