Valuation of any firm may be a difficult task. And when it comes to the business value of a troubled firm, the task becomes much more complex and critical.
Fremont, CA: Economic and financial anguish are the two categories of distress. Cultural or technical changes, global economic decline, and wars or other geopolitical clashes are all factors that contribute to economic suffering. Few of the variables are transient, while others may result in long-term changes to the corporate landscape. In addition, economic suffering frequently leads to financial distress. Firms in financial difficulties cannot satisfy their financial commitments or repay their creditors. Stagnant or declining revenue, shrinking margins, high leverage, ballooning interest costs, capital blockage, increased customer and employee attrition, shrinking or negative margins, asset divestitures, and a lack of confidence in management are some characteristics of financially distressed companies.
Distressed Company Business Valuation Methods
Modified Discounted Cash Flow Valuation:
The sole difference between the modified and classic discounted cash flow techniques is that in this method, the cash flows are adjusted for the risk of default. The following is the formula for calculating projected cash flow:
SUM of Expected Cash Flows (Estimated cash flow for each scenario*Scenario probability)
It should be noted that the adjustment for hardship is cumulative and will have a major influence on future cash flows.
To mitigate the possibility of discomfort in the discount rate, the following approaches can be used:
i) The bottom-up unlevered beta should be employed, and the subject company's present-day debt to equity ratio and effective tax rate should be RE levered. Because distressed agencies frequently have high debt-to-equity ratios and have zero effective tax rates (because they are loss-making), the levered beta that will be better will consider the risk of distress.
ii) Another option is to estimate a distressed top rate, which will be added to the equity price derived using widely used methods. For example, one way to calculate the distress premium is to compare the company's pre-tax cost of debt to the cost of debt in the industry. For instance, if the firm has a pre-tax cost of debt of 16% and the industry's cost of debt is 8%, the distress premium is 8%.
Distress Value plus Discounted Cash Flow Valuation
The following formula is used to calculate in this method:
DCF value of equity on an ongoing basis (1 – the probability of distress) + Distress sale value of equity (Probability of pain)During the business appraisal process, the following considerations should be kept in mind:
• The business valuation should be done using the going concern assumption, which includes a traditional valuation.
• The likelihood of distress should be estimated.
ØCalculate the equity's distressed selling value.
Relative Value
This strategy is further subdivided into two techniques. They are as follows:
The difficulty with the first strategy is that it may not always be possible to find comparable struggling firms. Therefore, in the second method, the troubled firm is considered healthy in the future. As a result, an estimate is created based on its future worth, which is then rediscounted to get at a going-concern value, to which the risk of distress and distress sale revenues are added to arrive at the final deal.
