Implementation of an Option Pricing-Based Bond Valuation Model for Corporate Debt and Its Components

Abstract

INTRODUCTION This paper describes the binomial option pricing-based bond value estimation procedure used in our study, “Option Pricing-Based Bond Value Estimates and a Fundamental Components Approach to Account for Corporate Debt,” (Barth et al. 1998). That study provides evidence on the relevance and reliability of option pricing-based value estimates for bonds and their components, i.e., conversion, call, put, and sinking fund provisions. Although the prior study provides a brief overview of the model’s implementation, i.e., how to estimate total bond and component values, the objective of this paper is to provide a fuller set of details to permit the model’s implementation by others, including other researchers and financial statement preparers. We also aim to enhance their understanding of option pricing-based debt and component valuation. To achieve our objective, we present several examples based on the binomial or twostate option pricing model of Cox et al. (1979) and Rendleman and Bartter (1979) to illustrate accounting issues associated with the valuation of corporate debt and its components. In contrast to the Black and Scholes (1973) (hereafter the Black-Scholes model) and related option pricing models derived using the mathematics of stochastic calculus,