Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition

CHAPTER 30

Valuing Equity in Distressed Firms

Chapter 22 examined how discounted cash flow models could be adapted to value firms with negative earnings. Most of the solutions estimated the expected cash flows into the future, and assumed that an improvement in margins or earnings would result in positive cash flows and firm value. In the special case where the firm has substantial amounts of debt, we argued that there is a very real possibility of defaulting on the debt and going bankrupt. In these cases, discounted cash flow valuation may be an inadequate tool for estimating value. This chapter looks at firms with negative earnings, significant assets in place, and substantial debt. We argue that the equity investors in this firm, given limited liability, have the option to liquidate the firm and pay off the debt. This call option on the underlying firm can add value to equity, especially when there is significant uncertainty about the value of the assets.

EQUITY IN HIGHLY LEVERED DISTRESSED FIRMS

In most publicly traded firms, equity has two features. The first is that the equity investors run the firm and can choose to liquidate its assets and pay off other claim holders at any time. The second is that the liability of equity investors in some private firms and almost all publicly traded firms is restricted to their equity investments in these firms. This combination of the option to liquidate and limited liability allows equity to have the features of a call option. In firms ...