bringtheeffectsofdistressintobothexpectedcashflowand
discount rates.
Estimating Expected Cash Flows
Toconsidertheeffectsofdistressonadiscountedcashflow
valuation,wehavetoincorporatetheprobabilitythatafirm
will not survive intothe expectedcash flows.In its most
complete form, this would require that we consider all
possible scenarios,rangingfromthemost optimisticto the
most pessimistic, assign probabilities to each scenario and
cash flowsunder each scenario,and estimate theexpected
cash flows each year.
whereπjtistheprobabilityofscenariojinperiodtandcash
flowjtisthecashflowunderthatscenarioandinthatperiod.
These inputs have to be estimated each year, since the
probabilitiesandthecashflowsarelikelytochangefromyear
to year.
A shortcut, albeit an approximate one, would require
estimatesforonlytwoscenarios—thegoingconcernscenario
andthedistressscenario.Forthegoingconcernscenario,we
couldusetheexpectedgrowthratesandcashflowsestimated
under theassumptionthat thefirmwill benursed backto
health.Underthedistressscenario,wewouldassumethatthe
firm will be liquidated for its distress sale proceeds. Our
expected cash flow for each year then would be: