Abstract
We examine the role of default risk and growth option factors, derived from option theory, besides that of earnings and book value of equity, in explaining the market value of equity. The default risk factor is measured by the option-based probability of default at debt's maturity, while the growth factor captures the upside growth option potential. Our main sample consists of 965 U.S. firms that filed for bankruptcy during 1992-2002. We also use three additional sub-samples of healthy firms as controls, with varying degrees of financial distress and growth prospects, to examine the conditionality of the impact of these factors. Our results confirm that the growth option factor dominates the role of book equity (and net income) in proxying for unrecognized net assets. The default risk factor seems to have a mixed effect: a traditional distress risk penalty with a negative impact on equity value for distressed firms or value firms on main exchanges; and a (equityholders') default option, reflected positively in current equity market values in the case of more volatile firms traded on Nasdaq.
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