Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 17

Distressed Businesses

Introduction

What Is Distress?

Valuing Firms in Distress

Changing Capital Structure

Adjusted Present Value

Option Valuation

Other Considerations

Bankruptcy Prediction Models

Accounting-Ratio-based Models

Market-based Models

Comparing the Models

Cost of Capital for Distressed Firms

WACC Considerations

Cost of Equity Capital Considerations

Valuing Companies Emerging from Bankruptcy

Levering Beta for a Highly Leveraged Company

Cost of Distress

Summary

Additional Reading

Appendix 17A: Cost of Capital and the Valuation of Worthless Stock

INTRODUCTION

The standard cost of equity capital models (e.g., the capital asset pricing model [CAPM]) and standard application of a discounted cash flow (DCF) method assume that the business continues as a going concern. However, a company may be distressed. What is distress? While there is no universal definition, one paper defines an industry as distressed if the median sales growth of pure play firms in an industry is negative and the median stock return is −30%.¹

Valuations of distressed companies differ from other valuations.²

First, distress risk indicators are not released at scheduled times (unlike financial statements). There are no universally accepted indicators of distress, and distress risk must be estimated from a variety of sources, including market and accounting data; relevant information likely is changing, sometimes rapidly. Monitoring the changing conditions can be a challenging task.

Second, standard ...