Given the likelihood and consequences of distress, it seems foolhardy to assume that we can ignore this possibility when valuing a firm, and particularly so, when we are
2 For an examination of the theory behind indirect bankruptcy costs, see Opler, T. and S. Titman, 1994, Financial Distress and Corporate Performance. Journal of Finance 49, 1015-1040. For an estimate on how large these indirect bankruptcy costs are in the real world, see Andrade, G. and S. Kaplan, 1998, How Costly is Financial (not Economic) Distress? Evidence from Highly Leveraged Transactions that Become Distressed. Journal of Finance. 53, 1443-1493. They look at highly levered transactions that subsequently became distressed snd conclude that the magnitude of these costs ranges from 10% to 23% of firm value.
valuing firms in poor health and with substantial debt obligations. So, what you might wonder, are the arguments offered by proponents of discounted cash flow valuation for not explicitly considering the possibility of firms failing? We will consider five reasons often provided by for this oversight. The first two reasons are offered by analysts who believe that there is no need to consider distress explicitly, and the last three reasons by those who believe that discounted cashflow valuations already incorporate the effect of distress.
1. We value only large, publicly traded firms and distress is very unlikely for these firms.
It is true that the likelihood of distress is lower for larger, more established firms, but experience suggests that even these firms can become distressed. The last few months of 2001 saw the astonishing demise of Enron, a firm that had a market capitalization in excess of $ 70 billion just a few months previously At the end of 2001, analysts were openly discussing the possibility that large firms like Kmart and Lucent Technologies would be unable to make their debt payments and may have to declare bankruptcy. In 2006, the same talk could be heard about GM and Delta Airlines. The other problem with this argument, even if we accept the premise, is that smaller, high growth firms are traded and need to be valued just as much as larger firms. In fact, we could argue that the need for valuation is greater for smaller firms, where the uncertainty and the possibility of pricing errors are greater.
2. We assume that access to capital is unconstrained
In valuation, as in much of corporate finance, we assume that a firm with good investments has access to capital markets and can raise the funds it needs to meet its financing and investment needs. Thus, firms with great growth potential will never be forced out of business because they will be able to raise capital (more likely equity than debt) to keep going. In buoyant and developed financial markets, this assumption is not outlandish. Consider, for instance, the ease with which new economy companies with negative earnings and few if any assets were able to raise new equity in the late 1990s. However, even in a market as open and accessible as the United States, access to capital dried up as investors drew back in 2000 and 2001. In summary, then, we may have been able to get away with the assumption that firms with valuable assets will not be forced into a distress sale in 1998 and 1999, but that assumption would have been untenable in 2001.
3. We adjust the discount rate for the possibility of distress
The discount rate is the vehicle we use to adjust for risk in discounted cash flow valuation. Riskier firms have higher costs of equity, higher costs of debt and usually have higher costs of capital than safer firms. A reasonable extension of this argument would be that a firm with a greater possibility of distress should have a higher cost of capital and thus a lower firm value. The argument has merit up to a point. The cost of capital for a distressed firm, estimated correctly, should be higher than the cost of capital for a safer firm. If the distress is caused by high financial leverage, the cost of equity should be much higher. Since the cost of debt is based upon current borrowing rates, it should also climb as the firm becomes more exposed to the risk of bankruptcy and the effect will be exacerbated if the tax advantage of borrowing also dissipates (as a result of operating losses). Ultimately though, the adjustment to value that results from using a higher discount rate is only a partial one. The firm is still assumed to generate cash flows in perpetuity, though the present value is lower. A significant portion of the firm's current value still comes from the terminal value. In other words, the biggest risk of distress that is the loss of all future cash flows is not adequately captured in value.
4. We adjust the expected cash flows for the possibility of distress
To better understand this adjustment, it is worth reviewing what the expected cash flows in a discounted cash flow valuation are supposed to measure. The expected cash flow in a year should be the probability-weighted estimate of the cash flows under all scenarios for the firm, ranging from the best to the worst case. In other words, if there is a 30% chance that a firm will not survive the next year, the expected cash flow should reflect both this probability and the resulting cash flow. In practice, we tend to be far sloppier in our estimation of expected cash flows. In fact, it is not uncommon to use an exogenous estimate of the expected growth rate (from analyst estimates) on the current year's earnings or revenues to generate future values. Alternatively, we often map out an optimistic path to profitability for unprofitable firms and use this path as the basis for estimating expected cash flows. We could estimate the expected cash flows under all scenarios and use the expected values in our valuation. Thus, the expected cash flows would be much lower for a firm with a significant probability of distress. Note, though, that contrary to conventional wisdom, this is not a risk adjustment. We are doing what we should have been doing in the first place and estimating the expected cash flows correctly. If we wanted to risk-adjust the cash flows, we would have to adjust the expected cash flows even further downwards using a certainty equivalent.3 If we do this, though, the discount rate used would have to be the riskfree rate and not the risk-adjusted cost of capital. As a practical matter, it is very difficult to adjust expected cash flows for the possibility of distress. Not only do we need to estimate the probability of distress each year, we have to keep track of the cumulative probability of distress as well. This is because a firm that becomes distressed in year 3 loses its cash flows not just in that year but also in all subsequent years.
5. We assume that even in distress, the firm will be able to receive the present value of expected cash flows from its assets as proceeds from the sale.
The problem with distress, from a DCF standpoint, is not that the firm ceases to exist but that all cash flows beyond that point in time are lost. Thus, a firm with great products and potentially a huge market may never see this promise converted into cash flows because it goes bankrupt early in its life. If we assume that this firm can sell itself to the highest bidder for a distress sale value that is equal to the present value of expected future cash flows, however, distress does not have to be considered explicitly. This is a daunting assumption because we are not only assuming that a firm in distress has the bargaining power to demand fair market value for its assets, but we are also assuming that it can do this not only with assets in place (investments it has already made and products that it has produced) but with growth assets (products that it may have been able to produce in the future).
In summary, the failure to explicitly consider distress in discounted cash flow valuation will not have a material impact in value if any the following conditions hold:
1. There is no possibility of bankruptcy, either because of the firm's size and standing or because of a government guarantee.
3 A certainty equivalent cashflow replaces an uncertain cash flow with an equivalent riskless cashflow. Thus, an expected cashflow of $ 125 million will be replaced by a riskless cashflow of $ 100 million. The more uncertain the cash flow, the greater the downward adjustment.
2. Easy access to capital markets allows firms with good investments to raise debt or equity capital to sustain themselves through bad times, thus ensuring that these firms will never be forced into a distress sale.
3. We use expected cash flows that incorporate the likelihood of distress and a discount rate that is adjusted for the higher risk associated with distress. In addition, we have to assume that the firm will receive sale proceeds that are equal to the present value of expected future cash flows as a going concern in the event of a distress sale.
If these conditions do not hold, and it is easy to make an argument that they will not for some firms at some points in time, discounted cash flow valuations will overstate firm value.
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