negotiationsareprivate(betweenthedistressedfirm
and the lenders).- Weshouldupdatetheestimatedmarketvalueofdebt
frequently,sincethedefaultriskofdistressedfirms
canchangesubstantiallyfromperiodtoperiod.Even
ifthedebtisnottraded,itisneverappropriatewith
distressedfirms tousethebookvalueofdebtasa
proxy for the market value of debt. Instead, we
should estimate the market value of debt, treating
book debt like a corporate bond. - Whenconfronted with convertible debt,we should
striptheconversionoptionfromthedebtandtreatit
asequity.Again,asimplewaytodothisistovalue
theconvertibledebtasifitwerestraightdebt—this
will yield the debt portion of the convertible
debt—and consider the difference between the
marketvalueoftheconvertibledebtandthestraight
debt portion as equity.
Ingeneral,valuingadistressedfirmasawholeisfareasier
thanvaluingequityinthesamefirm,largelybecausethedebt
outstanding will vary over time.
Equity as an Option
Inmostpublicly tradedfirms,equityhastwofeatures.The
firstisthattheequityinvestorsrunthefirmandcanchooseto
liquidate its assetsand pay off otherclaim holders atany
time. Thesecondisthat theliabilityofequity investorsin
some private firms and almost all publicly tradedfirms is
restricted to their equity investments in these firms. This
combination oftheoptionto liquidate and limitedliability
allowsequitytohavethefeaturesofacalloption.Infirms