probabilities of distress (and survival) each year for the
forecastperiod.Consequently,theexpectedcashflowsmay
notincorporatetheeffectsofdistresscompletely.Inaddition,
it is difficult to bring both the going concern and the
distressedfirmassumptionsintothesamemodel.Weattempt
to do sousingprobabilities, but thetwo approaches make
differentandsometimescontradictoryassumptionsabouthow
markets operate and how distressed firms evolve over time.
Dealing with Distress Separately
Analternativetothemodified discountedcashflow model
presentedin the precedingsection isto separate thegoing
concernassumptionsandthevaluethatemergesfrom them
fromtheeffectsofdistress.Tovaluetheeffectsofdistress,
we estimate the cumulative probability that the firm will
becomedistressedovertheforecastperiod,andtheproceeds
thatwewillobtainfromthedistresssale.Thevalueofthe
firm can then be written as:
whereπDistressisthecumulativeprobabilityofdistressover
thevaluationperiod.Inadditiontomakingvaluationsimpler,
italsoallowsustomakeconsistentassumptionswithineach
valuation.
Youmaywonderaboutthedifferencesbetweenthisapproach
andthefarmoreconventionaloneofestimatingliquidation
value for deeply distressed firms. You can consider the
distresssalevaluetobeaversionofliquidationvalue,andif
youassumethattheprobabilityofdistressis1,thefirmvalue
will,infact,convergeonliquidationvalue.Theadvantageof