basedonpromisedcashflows(couponsandfacevalue)rather
than expected cash flows. The presumption in a going
concernvaluationisthatthepromisedcashflowshavetobe
madeforthefirmtoremainagoingconcern,anditisthus
appropriatetobasethecostofdebtonpromisedratherthan
expectedcashflows.Forafirmwithasignificantlikelihood
of distress, this presumption is clearly unfounded.
What are the estimation choices for distressed firms? To
estimatethecostofequity,wehavetwooptionsthatprovide
more reasonable estimates than regression betas:
- CAPM betas adjusted for distress. Instead of using
regressionbetas,wecouldusethebottom-upunleveredbeta
(theweightedaverage ofunlevered betasofthebusinesses
that the firm operates in) and the current market
debt-to-equityratioofthefirm.Sincedistressedfirmsoften
havehigh debt-to-equity ratios,brought about largely asa
consequenceofdroppingstockprices,thiswillleadtolevered
betas that are significantly higher than regression betas.
6 Ifwecouplethiswiththerealitythatmostdistressedfirms
areinnopositionto getanytaxadvantagesfromdebt,the
levered beta will become even higher.
Note,though,thatitisreasonabletoreestimatedebt-to-equity
ratiosandtaxratesforfutureyearsbasedonourexpectations
for the firm and adjust the beta to reflect these changes.
7
2.Distressfactormodels.Inadditiontothestandardfactorfor
marketrisk,wecouldaddaseparatedistressfactortothecost