Sunday, November 16, 2008

Oh, and Speaking of Insolvent...
(Options Again)

It seems to me that GM is probably "insolvent" already, in the sense that the value of its liabilities exceeds the value of its assets.*

But if it is insolvent, how come its equity is still trading at a positive number? Easy. Think of the equity as an out-of-the-money option--worth something as a lottery ticket, even if worth nothing at the moment.

Here's an example. LittleCo has assets of $80 and liabilities of $100. So, insolvent. If LittleCo liquidates today, its creditors get 80 cents on the dollar and the equity gets bubkas. But LittleCo has a chance to invest all $80 in a new project which will yield (a) $160 or (b) $80, with a 50 percent chance of each. This pencils out right: 0.5(160)+0.5(0)=80.

But from the standpoint of equity, there is the chance that something may turn up. How to measure the chance? Value the payoffs to equity. That would be: 0.5(160-100)+0.5(0)=30. So equity is worth $30, even though the company is insolvent. By the way, to double-check, figure the current market value of debt. The value is 0.5(100)+0.5(80)=50. Again, this pencils out right: $50+$30 = $80, so everything checks.

By the way, this is the same logic that leads to the conclusion that a homeowner whose mortgage is bigger than his house may nonetheless keep paying (link).

*In the bulldog of edition of this publication, I said it exactly backwarads. D'oh, no wonder my students don't understand me. And thanks, Taxmom.

1 comment:

Taxmom said...

Um don't mean to be dense but I thought you were insolvent if the value of your liabilities exceeded the value of your assets. Or are all these banks insolvent because they have so many assets on their books?