What does the Merton Model consider the capital structure of a borrower to be?

The Merton Model fundamentally conceptualizes the capital structure of a borrower as a call option on the assets of the firm. This approach stems from the idea that the equity holders of a firm have the rights to the residual cash flows after the firm's obligations to debt holders are met. In a sense, if the firm were to default, the equity holders lose their investment, akin to an option that is worthless when the underlying asset's price falls below the strike price.

In this model, the firm's assets can be viewed as the underlying asset of a call option, where the strike price is the total amount of debt owed by the firm. When the value of the firm's assets exceeds its liabilities, the equity holders effectively "exercise" their option, thus benefiting from the upside. Conversely, if the asset value falls below the debt level, the option becomes worthless, reflecting the loss in equity value.

This perspective aligns well with the principles of option pricing theory, leveraging the conceptual framework of financial options to analyze credit risk and capital structure decisions. Understanding the Merton Model in this light helps contextualize the risks associated with default and the behavior of different stakeholders in the capital structure.