thisapproachisthatitallows ustoconsiderthepossibility
that even distressed firms have a chance (albeit small) of
becoming going concerns.
Going Concern Discounted Cash Flow
Tovalueafirmasagoingconcern,weconsideronlythose
scenarioswherethefirmsurvives.Theexpectedcashflowis
estimated across only these scenarios and thus should be
higherthantheexpectedcashflowestimatedinthemodified
discountedcashflowmodel.Whenestimatingdiscountrates,
wemaketheassumptionthatdebtratioswill,infact,decrease
over timeif thefirmis overlevered,and thatthefirmwill
derive tax benefits from debt as it turns the corner on
profitability.Thisisconsistentwiththeassumptionthatthe
firmwillremainagoingconcern.Mostdiscountedcashflow
valuations that we observe in practice are going concern
valuations, though they may not come with the tag attached.
Alessprecisealbeiteasieralternativeistovaluethecompany
asif itwerea healthy companytoday.Thiswould require
estimatingthecashflowsthatthefirmwouldhavegenerated
ifitwereahealthyfirm,ataskmosteasilyaccomplishedby
replacing the firm’s operating margin by the average
operatingmarginofhealthyfirmsinthebusiness.Thecostof
capitalforthedistressedfirmcanbesettotheaveragecostof
capital for theindustry, and the valueof the firm canbe
computed. The danger with this approach is that it will
overstatefirmvaluebyassumingthatthereturntofinancial
health is both painless and imminent.
Estimating the Probability of Distress