Detal

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The Cost of Distress: Survival, Truncation Risk and Valuation Aswath Damodaran Stern School of Business

January 2006

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The Cost of Distress: Survival, Truncation Risk and Valuation

Traditional valuation techniques- both DCF and relative - short change the effects of financial distress on value. In most valuations, we ignore distress entirely and make implicit assumptions that are often unrealistic about the consequences of a firm being unable to meet its financial obligations. Even those valuations that purport to consider the effect of distress do so incompletely. In this paper, we begin by considering how distress is dealt with in traditional discounted cash flow models, and when these models value distress correctly. We then look at ways in which we can incorporate the effects of distress into value in discounted cashflow models. We conclude by looking at the effect of distress on relative valuations, and ways of incorporating its effect into relative value.

3 In both discounted cash flow and relative valuation, we implicitly assume that the firms that we are valuing are going concerns and that any financial distress that they are exposed to is temporary. After all, a significant chunk of value in every discounted cash flow valuation comes from the terminal value, usually well in the future. But what if the distress is not temporary and there is a very real chance that the firm will not survive to get to the terminal value? In this paper, we will argue that we tend to over value firms such as these in traditional valuation models, largely because is difficult to capture fully the effect of such distress in the expected cash flows and the discount rate. The degree to which traditional valuation models misvalue distressed firms will vary, depending upon the care with which expected cash flows are estimated, the ease with which these firms can access external capital market and the consequences of distress. In this paper, we will begin by...