Reading: Understanding and Valuing Debt and Equity

The decomposition of the firm's total payoff into a debt and an equity payoff is also helpful to better understand how we can value these financing instruments and, equally importantly, what the respective value drivers are. Remember from the beginning of this section, that the decomposition looked as follows:

In these graphs, the horizontal axis indicates the firm value at the time the firm's debt matures (in 1 year) and the vertical axis indicates the payoff to the respective stakeholders. These graphs show that debt and equity derive their value from the same "underlying asset," namely the overall value of the company. They can therefore be considered derivatives on the firm value and priced accordingly.