Answer 21

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Probability of distress

Discounted cashflow valuation is built on two fundamental assumptions. The first is that capital markets are open and always accessible; thus firms that need to raise fresh capital to cover cashflow needs do not have any trouble doing so. The other is that real asset markets are liquid. In other words, a company that ceases operations will still get the present value of the expected cashflows from its assets in a sale. In reality, capital markets sometimes shut down and distress sales are at discounted prices.

While adherents to DCF valuation will claim that the discount rates (costs of equity and capital) can be adjusted to reflect the likelihood and consequences of distress, discount rates are blunt instruments that are more suited for dealing with volatility risk (that earnings and cashflows will be volatile) than for truncation risk (i.e., that the firm will not be around in 3 years).

A better way to deal with the risk of truncation would be to do the following. First, assume that your firm will be a going concern and do a discounted cash flow valuation of it. Second, assess the probability that your firm will not be a going concern; a good place to look would be the bond market if the company has bonds outstanding. Third, estimate the distress sale value of the assets in the event of bankruptcy. Finally, compute the expected value of the firm = probability of going concern * DCF value + probability of distress * distress sale value.



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