The Cost of Distress: Survival, Truncation Risk and Valuation

Abstract

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.

Keywords: distress, value, adjusted present value, survival

JEL Classification: G12, G33