ofequity.Ineffect,this wouldmakethecost ofequityfor
distressedfirmsmuchhigherthanhealthyfirmsinthesame
business.Infact,somehaveattributedthehigherreturnsthat
FamaandFrench(1992)showareearnedbyfirmswithlow
price-to-bookratiostodistress;lowprice-to-bookstocks,they
argue, are more likely to be distressed.
8 Otherstudies,however,contestthisnotionbynotingthat
portfoliosofdistressedfirmshaveearnedlowerreturnsthan
portfolios of healthy firms historically.
9
Toestimatethecostofdebtforadistressedfirm,wewould
recommendusingtheinterestratebasedonthefirm’sbond
rating.Althoughthiswillstillyieldahighcostofdebt,itwill
bemorereasonablethantheyieldtomaturitywhendefaultis
viewed as imminent.
10
To compute the cost of capital, we need to estimate the
weightsofdebtonequity.Intheinitialyear,weshoulduse
thecurrentmarket debt-to-capitalratio(whichmaybevery
high for a distressed firm). As we makeour forecasts for
futureyearsandbuildinourexpectationsofimprovementsin
profitability, we should adjust thedebt ratio toward more
reasonablelevels.Theconventionalpracticeofusingtarget
debt ratios for the entire valuation period (which reflect
industryaveragesortheoptimalmix)canleadtomisleading
estimates of value for firms that are significantly overlevered.
Limitations of Approach
Thebiggestroadblocktousingthisapproachisthatevenin
its limited form, it is difficult to estimate the cumulative