– The equity of a firm with debt in its capital structure is actually a call option if interest and principal are paid to creditors, shareholders own the underlying assets of the firm; if interest and principal are defaulted, creditors will end up with the assets.
– If the So/X ratio is high, the option is well in the money, which implies a low proportion of debt in the company’s capital structure. If low the company has lots of debt.
– An increase in σ means that the operating assets of the firm are more risky.
– Specific actions taken by geared companies can shift wealth from debt holders to shareholders.