CHAPTER 17
The Cost of Distress
Inbothdiscounted cashflow(DCF)and relativevaluation,
weimplicitlyassumethatthefirmsthatwearevaluingare
goingconcernsand thatanyfinancialdistressthattheyare
exposed to is temporary. After all, a significant chunk of
valueineverydiscountedcashflowvaluationcomesfromthe
terminal value,usually wellin thefuture. But what if the
distressisnottemporaryandthereisaveryrealchancethat
thefirmwillnotsurvivetogettotheterminalvalue?Inthis
chapter, wearguethat wetendto overvaluefirms such as
these in traditional valuation models, largely because it is
difficult to capture fully theeffect of such distress in the
expected cash flows and thediscount rate. The degree to
whichtraditionalvaluationmodelsmis-valuedistressedfirms
willvary,dependingonthecarewithwhich expectedcash
flows are estimated, the ease with which these firms can
access external capital markets, and the consequences of
distress.
We begin by looking at the underlying assumptions of
discounted cash flow valuation, why DCF models do not
explicitly consider the possibility of distress, and when
analystscangetawaywithignoringdistress.Wefollowupby
considering ways in which we can adjustdiscounted cash
flowmodelstoexplicitlyallowforthepossibilityofdistress.
Inthenextpartofthechapter,weconsiderhowdistressis
considered(ormoreoftenignored)inrelativevaluationand
waysofadjustingmultiplesforthepossibilityoffailure.We
willclose thechapter by lookingatwhy equity in deeply