distress—that is, the loss of all future cash flows—is not
adequately captured in value.
4.Weadjusttheexpectedcash flowsfor thepossibility of
distress. To better understand this adjustment, it is worth
reviewingwhattheexpectedcashflowsinadiscountedcash
flowvaluationaresupposedtomeasure.Theexpectedcash
flowinayearshouldbetheprobability-weightedestimateof
thecashflowsunderallscenariosforthefirm,rangingfrom
thebestto theworstcase.In otherwords,if thereisa 30
percentchancethatafirmwillnotsurvivethenextyear,the
expectedcashflowshouldreflectboththisprobabilityandthe
resultingcashflow.Inpractice,wetendtobefarsloppierin
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 thecurrent year’s
earningsorrevenuestogeneratefuturevalues.Alternatively,
we often map out an optimistic path to profitability for
unprofitablefirmsandusethispathasthebasisforestimating
expectedcash flows.Wecouldestimate theexpectedcash
flowsunderallscenariosandusetheexpectedvaluesinour
valuation. Thus, the expected cash flows would be much
lower for a firm with a significant probability of distress.
Note,though, thatcontraryto conventionalwisdom,this is
not a riskadjustment.Wearedoing what weshould have
beendoinginthefirstplaceandestimatingtheexpectedcash
flowscorrectly.Ifwewantedtorisk-adjustthecashflows,we
wouldhaveto adjusttheexpectedcash flowsevenfurther
downward using a certainty equivalent.
3 Ifwedothis,though,thediscountrateusedwouldhaveto
betherisk-freerateandnottherisk-adjustedcostofcapital.
Asa practicalmatter,itisverydifficulttoadjustexpected