raisecapital(morelikelyequitythandebt)tokeepgoing.In
buoyantanddevelopedfinancialmarkets,thisassumptionis
not outlandish.Consider, forinstance, theeasewithwhich
neweconomycompanieswithnegativeearningsandfew,if
any,assetswereabletoraisenewequityinthelate1990s.
However, evenin a market asopen and accessibleas the
UnitedStates,accessto capital driedupas investors drew
backin 2000 and2001.Insummary,then,wemayhavebeen
abletogetawaywiththeassumptionthatfirmswithvaluable
assetswillnotbeforcedintoadistresssalein 1998 and1999,
but that assumption would have been untenable in 2001.
3.Weadjustthediscountrateforthepossibilityofdistress.
Thediscountrateisthevehicleweusetoadjustforriskin
discounted cash flow valuation. Riskier firms have higher
costsofequity,highercostsofdebt,andusuallyhighercosts
of capital thansafer firms. A reasonable extensionof this
argumentwouldbethatafirmwithagreater possibilityof
distressshouldhaveahighercostofcapitalandthusalower
firmvalue.Theargumenthasmerituptoapoint.Thecostof
capitalfor adistressed firm,estimatedcorrectly,shouldbe
higherthanthecostofcapitalforasaferfirm.Ifthedistressis
causedbyhighfinancialleverage,thecostofequityshouldbe
much higher. Since the cost of debt is based on current
borrowing rates,itshould also climb as thefirm becomes
moreexposedtotheriskofbankruptcy,andtheeffectwillbe
exacerbatedifthetaxadvantageofborrowingalsodissipates
(as a result of operating losses). Ultimately, though, the
adjustmenttovaluethatresultsfromusingahigherdiscount
rateisonlyapartialone.Thefirmisstillassumedtogenerate
cashflowsinperpetuity,thoughthepresentvalueislower.A
significantportionofthefirm’scurrentvaluestillcomesfrom
the terminal value. In other words, the biggest risk of