EC5604

Corporate Finance
Valuing Risky Corporate Debt
in the Real and Monetary Economies
Lecture 1
You know a lot already about valuing risky debt. If
you are in doubt about that, review Lectures 11, 14 and
the first few slides of Lecture 15 for EC5601. We need
to expand on that material a bit.
Recall that we learned if corporate debt is risky, the
shareholders possess a put option on the assets of the
firm. Thus the value of risky corporate debt can be
calculated as the value of the debt, as if it were
riskless, minus the value of the put on the firms assets.
Example: Assume we have no taxes. The value of Firm
B is 10,000 and has a required return on assets, rA =
10%.
Firm B, Assets = 10,000
1/2

4,000
Debt = 4,000
Equity = 0

1/2

18,000
Debt = 5,000
Equity = 13,000

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Corporate Finance

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Slide 2

Suppose that Firm B is levered with a 5000 nominal

Debt. The Debt is clearly risky from the depiction of
its FVs above.
How much is the debt worth? Recall,
Debt = PV(riskless Debt) - put option on Firms assets
Lets value the put first.
Asset Value =10,000

4,000

18,000

put value @5,000 strike price

1,000

If we short-sell the assets and lend the PV(18,000),

we expend,
18,000
10,000 - PV(18,000) 10,000
7142.86
1.05
which leads to

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Corporate Finance

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Slide 3

-7,142.86

18,000 - 4,000 =
14,000

18,000 - 18,000
= 0

These FVs are clearly worth 14 puts on the firms

assets, therefore one put is worth 510.20. The Debts
value thus is 5,000 / 1.05 510.20 4,251.70. Equity in Firm B is worth 5,748.30. Recall that this is
but a reflection of Put-Call Parity. With the risk of
financial distress, shareholders who hold a put option
on the firms assets own Equity that is worth more than
VASSETS VDEBT(riskless). Equity is actually worth
VEQUITY = VASSETS VDEBT(riskless) + VPUT.
You will not be surprised that a risk-component of any
financial liability, such as Debt or Equity, will have
risk that is associated with variation in or uncertainty
surrounding the purchasing power of money. In this
course we do not complicate matters by worrying
about how risks in the real economy translate into risks
in monetary values of corporate liabilities. You should
be aware, however, that interesting complications can

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Corporate Finance

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Slide 4

arise and you are now in a good position to understand

their nature.
First, we need some terminology. Let PGoods be the
money price of real goods and services. Then let
PGoods indicate the change in such prices. It follows
then that PGoods/PGoods(last periods) is the familiar
rate of inflation. The purchasing power of money is
1/PGoods, the number of real goods and services that can
be purchased by one unit of money.
One famous way that economists account for the
difference between nominal and real interest rates is
with the Fisher (Irving) Equation. The nominal rate of
interest is the money rate of interest that we see in the
everyday world. The real rate of interest is a theoretical
construct and, except in special circumstances, is not
easy to observe. The real rate of interest is the money
rate of interest when holding the purchasing power of
money (PPM) constant. Let us write the Fisher
equation in terms of returns on corporate Debt.

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Slide 5

Required Rate of Return on Nominal Debt =

Required Rate of Return on Debt(PPM constant) +
Expected Rate of Inflation
The idea, of course, is a very simple one as originally
expressed by Fisher. If you are a debtholder, you will
require a higher rate of return on Debt when you
expect the purchasing power of money to erode.
Appealingly simple as it is, we can see quite
straightforwardly that the Fisher Equation is wrong
and in many circumstances would give a misleading
idea of how nominal required rates of return are
affected by purchasing power risk. The reason it is
wrong is that a nominal bond has an option component
in it and this is a call option on future purchasing
power. Without a correct calculation of this options
value, we cannot come to a correct value for the
nominal bond and therefore we cannot correctly
calculate its required return.
Before proceeding, let us apply the Fisher Equation to
a simple situation that has occurred in the past
hyperinflations. There are historical examples in
interwar Germany and post-war Eastern Europe
(Hungary) and China. Much modern monetary history
of South American economies has been nearly

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Slide 6

hyperinflationary and today we have the example

presented to us by Robert Mugabes Zimbabwe.
Suppose the expected rate of inflation was 10,000%
per annum and that the real required return on Debt
was 5%. The Fisher Equation therefore says that the
nominal required return is 10,005%. Now let us ask
what would a nominal Debt of 100 be worth.
100/(1+rnominal) = 100/101.05 1
In other words, nominal bonds should be nearly
worthless in hyperinflations, if the hyperinflation is
expected to continue and if the Fisher Equation is
correct. What do we see in hyperinflations? Bond
values do tend to be quite low, but not nearly as low as
the Fisher Equation would suggest. In much of postwar South America inflation rates have consistently
been on the order of hundreds, and sometimes,
thousands, of percent per annum. Yet rates of return on
nominal bonds have generally been on the order of
20% to 50% per annum.
Why do nominal bonds have persistent value in
hyperinflations? Because nominal bonds contain a call
option on future purchasing power and this call option
will likely be exercised in the contingency that the

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Corporate Finance

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Slide 7

hyperinflation abates. We know that in option analysis

the likelihood that an option will be exercised can be
quite small, yet the option can still have great PV if the
net payoff (payoff minus strike price) is quite large
when the option is exercised. This is what is going on
with nominal bond values in hyperinflations. Let us
work through an example.
Imagine that in the real economy, the economic sector
in which real goods and services are produced, there is
an expected and required rate of return of 10%. Let us
call real goods and services corn. Corn, as you
know, can be either eaten or shoved back into the
ground as seed. There is a certain riskiness to
production in the real economy and it is expressed as
below.
100 corn units as seed
1/2

90 corn units
production

1/2

130 corn units

production

This real economy is, of course, embedded in a money

economy that has its own peculiar riskinesses. Suppose

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Slide 8

the current price of corn is 1 per unit (PGoods = 1),

but there is a substantial chance of price inflation.
PGoods = 1
1/2

1/2

PGoods = 5

PGoods = 1

Note that the expected rate of inflation is 200%. The

Fisher equation tells us therefore that the required
nominal rate of return should be 210%. A nominal
100 bond should be worth 100/3.1 = 32.26. What is
the future purchasing power of a 100 nominal bond?
Purchasing Power of
100 nominal bond
1/2

20 corn units

1/2

100 corn units

Clearly, a nominal bond can deliver 20 units of corn

risklessly. Supposing that the real risk-free rate is 5%,
those riskless 20 corn units have a present value of 19
corn units. But there are the remaining risky future

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Corporate Finance

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Slide 9

corn units that the nominal bond can deliver. They

look like this.
Risky purchasing power
of 100 nominal bond
1/2

0 corn units

1/2

80 corn units

Now, do these future risky corn units have a present

value that is properly represented as an option value?
Yes, they do! They represent FVs from an option
because if you own a 100 nominal bond, you do not
have to exchange that bond for corn in the next period.
You can simply exchange the bond for another bond
and wait until purchasing power of bonds is restored to
your liking. You will more likely exchange the bond
for real goods when the purchasing power of bonds
and money is good. In other words, you can choose
when to exercise your consumption option.
Can we price this option? Yes, its easy. We price it
first in the real economy. The future corn units above
are exactly what we would get if we currently shortsold the production by 100 units of seed corn and
simultaneously lent the PV of 90 corn units. We would

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Corporate Finance

Lecture 1

Slide 10

end up with either 90+90 corn units or 130+90 (-40)

corn units. The current corn flows that result from
such transactions would be +100-90/1.05, or 14.3. This
is the value of a call option on the production from 100
units of seed corn at a strike price of 90 corn units.
The PV therefore of our future optional corn units at
the top of SLIDE 9 will be double the option value we
have just calculated, or 28.6 units of corn. Recall that
the risk-free portion of the nominal bond was worth 19
units of corn. Therefore a 100 nominal bond is worth
19 + 28.6 units of current corn, or 47.6 corn units. At
the current price of 1/corn, the nominal bond should
be worth 47.60, a bit more than the 32.26 predicted
by the Fisher Equation. The required nominal rate of
return is 100/47.60 1 = 110%, a good deal lower
than the 210% predicted by the Fisher Equation.
So, valuing nominal financial liabilities in a world of
purchasing power uncertainty is important and subtle.
It is too bad that the Fisher approach is a bit too crude.
What you should appreciate is that valuing of
corporate liabilities, such as Debt, in a world where we
have to worry about the interaction of purchasing
power risks, as well as the risks in the underlying real
economy will be challenging indeed.