A comparison of Merton's option pricing model of corporate debt valuation to the use of book values [An article from: Journal of Corporate Finance]

This digital document is a journal article from Journal of Corporate Finance, published by Elsevier in 2005. The article is delivered in HTML format and is available in your Amazon.com Media Library immediately after purchase. You can view it with any web browser.

Description:
Many studies use the book value of debt as a proxy for its market value because most corporate debt does not trade. I call this practice the book value of debt (BVD) approximation, and it appears to be justified by the observation that the average market value of debt is close to its book value. Many corporate bonds, however, trade at values significantly different from their book values, and consequently the BVD approximation can create important biases. I compare the accuracy of the BVD approximation to Merton's option pricing (OPT) model of corporate debt valuation, and find consistent evidence that the Merton model provides more accurate estimates. I also show that this model is an easily estimated alternative to the BVD approximation. In short, the BVD approximation not only creates significant biases, but it is also an unnecessary simplification.