What is the 'option value of equity' for a distressed company?

Answer

Even when a distressed company's equity is economically worthless today (debt > enterprise value), the equity may still trade at a small positive value because it functions like an out-of-the-money call option: if the business recovers, equity holders capture all the upside; if it fails, they lose their (already small) investment. The option value depends on time to maturity (longer = more valuable), business volatility (higher = more valuable), and how 'underwater' the equity is.