distresspaper

distresspaper - 1 The Cost of Distress: Survival,...

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1 The Cost of Distress: Survival, Truncation Risk and Valuation Aswath Damodaran Stern School of Business January 2006
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2 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.
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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 looking at the underlying assumptions of discounted cash flow valuation, why DCF models do not explicitly consider the possibility of distress and when analysts can get away with ignoring distress. We will follow up by considering ways in which we can adjust discounted cashflow models to explicitly allow for the possibility of distress. In the next part of the paper, we consider how distress is considered (or as is more often, ignored) in relative valuation and ways of adjusting multiples for the possibility of failure. We will close the paper by looking at why equity in deeply distressed firms may continue to have value because of the limited liability feature of publicly traded equity. The Possibility and Consequences of Financial Distress Growth is not inevitable and firms may not remain as going concerns. In fact, even large publicly traded firms sometimes become distressed for one reason or the other and the consequences for value can be serious. In this section, we will consider first how common it is for firms to become distressed and follow up by looking at the
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This note was uploaded on 12/01/2011 for the course FINANCE 350 taught by Professor Aswath during the Summer '10 term at NYU.

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distresspaper - 1 The Cost of Distress: Survival,...

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