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CHAPTER 1: INTRODUCTION

1.1 Background of the Study

In recent years, the financial landscape—both in India and globally—has witnessed an

upsurge in corporate distress, business failures, and fundamental shifts brought by economic
volatility, stricter regulations, and unprecedented crises like the COVID-19 pandemic. As
uncertainty grows, the need for robust, adaptable, and realistic valuation practices becomes
paramount for investors, regulators, and corporate decision-makers alike. The challenge is
magnified when dealing with firms experiencing operational decline, financial instability, or
market underperformance—scenarios where conventional valuation models often prove
insufficient or even misleading.
It is in this environment of heightened complexity that valuation transitions from a technical
exercise to a critical, real-world decision-making tool. In particular, the valuation of
distressed and underperforming firms moves beyond simple calculations and enters the realm
of nuanced judgment, professional skepticism, and advanced analytical skills. This dimension
of valuation—the so-called “dark side”—remains underexplored in academic literature and is
often bypassed in mainstream industry practice in favor of more straightforward, growth-
oriented case studies.
The need to bridge this gap between theory and practice became especially evident during my
three-month internship at Elite Valuation Interstellar in Ahmedabad. As a leading, SEBI-
registered and IBBI-recognized professional valuation and transaction advisory firm, Elite
Valuation exposed me to a diverse range of assignments, including the practical valuation of
firms facing distress and turnaround situations. This hands-on experience revealed many of
the real-world challenges valuation professionals face: ambiguous data, dynamic market
realities, stakeholder pressure, and the unique limitations of standard models. It was through
such assignments that I recognized the crucial importance—and difficulty—of valuing
troubled firms, as well as the profound implications such valuations hold for investment
outcomes, restructurings, and regulatory interventions.
To set a benchmark for best practices, my research also draws comparison to organizations
such as JM Financial, a prominent figure in India’s financial advisory sector. This
benchmarking enhances the rigor of the study and grounds its findings in what is achievable
by the industry’s most respected institutions.
Ultimately, the motivation behind choosing the topic, “The Dark Side of Valuation: Valuing
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Underperforming and Distressed Firms,” lies in my conviction that practitioners, academics,
and students alike need deeper, more practical insight into the realities of business valuation
when the stakes are highest and uncertainty is greatest. By critically examining the
intersection of theoretical frameworks and practical applications, this report aspires to
contribute not only to academic understanding but also to professional standards within the
field of financial valuation.

1.2 What is Valuation?

Valuation is the process of estimating the worth of an asset, company, or investment. In

financial terms, it is the present value of expected future cash flows generated by an asset or
firm, discounted at an appropriate rate that reflects its risk. Every asset—whether tangible
like real estate or intangible like brand value—has a value, and understanding that value is
crucial for making informed investment decisions.
Professor Aswath Damodaran, a global authority on valuation, explains that valuation is not
just about numbers but also about understanding the business and its environment. According
to him, "every asset has a value, and the key to successful investing is estimating that value
correctly and making decisions accordingly"¹.

1.2.1 Why is Valuation Important?

Valuation is at the core of decision-making in finance. Whether you are investing, selling,
buying, merging companies, or raising money—valuation tells you whether something is a
good deal or not.
1.2.1.1 Valuation Helps in Investment Decisions

 For Investors (like in stock markets):

o You don’t want to buy something more than it is worth.

o Example: If a stock is worth ₹100, but is selling for ₹70, that may be a good
investment.

 Different investor types use valuation differently:

o Fundamental Analysts use detailed valuation models (like DCF).

o Technical Analysts care more about Chart pattern, not value.

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 o Market Timers use it to guess whether the overall market is cheap or
expensive.

o Franchise Buyers (like Warren Buffett) only buy companies they understand
and are undervalued/underperforming.

1.2.1.2 Valuation in Mergers & Acquisitions (M&A)

 When one company buys another, valuation helps decide the right price to pay.

 It helps both:

o The buyer (how much should we offer?).

o The target company (is the offer good enough?).

 It also includes:

o Synergy effects (how much extra value can we create together?).

o Management changes (can better leadership improve the business and value?).

1.2.1.3 Valuation in Corporate Finance

 Corporate finance is all about making decisions that increase the value of the
company such as..

o Which projects to invest in?

o How to finance them (debt or equity)?

o Whether to pay dividends or reinvest profits?

All of these are guided by valuation.

 Example: If taking a new loan increases the firm’s value more than it costs, it’s a
good decision.

1.2.1.4 Valuation During Restructuring or Insolvency

 For distressed or underperforming companies, valuation becomes even more

important to determine.

o Should the company be sold?

o Should it be shut down or restructured?

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 o Can the business be saved and revived?

 Investors, lenders, and the government use valuation to measure damage, estimate
recovery, and plan resolutions.

Aswath Damodaran points out:

“Valuation is hardest when you need it the most — when a company is in trouble or when
cash flows are uncertain.”

1.3 The Real-World Need for Valuation

In the dynamic world of business and finance, valuation is far more than a theoretical
exercise; it is a practical necessity guiding a multitude of crucial decisions. For investors, it
serves as the foundation for distinguishing between fairly priced opportunities and potential
pitfalls. Accurate valuation enables them to identify undervalued assets worth investing in, as
well as to avoid overpriced or risk-laden options.
Valuation is equally vital for corporate decisions such as mergers, acquisitions, and
restructuring. Before embarking on a merger or acquisition, both sides rely on valuation
techniques to determine a fair transaction price, negotiate terms, and ensure stakeholders’
interests are protected. For companies facing distress, valuation takes on an even more
critical role. Here, it may decide whether an organization will be liquidated, reorganized, or
receive new investment. In distressed circumstances, valuers must grapple with uncertain
cash flows, unreliable data, and legal complexities—conditions that render traditional
methods more challenging and amplify the importance of expert judgment.
The significance of valuation extends to everyday business operations as well. Companies
use valuation for financial reporting, ensuring their assets and liabilities are accurately
reflected in their statements—information that regulators, lenders, and shareholders closely
scrutinize. Furthermore, valuation is central to risk management; by regularly assessing the
worth of investments and assets, businesses can identify emerging threats, adapt to market
changes, and make strategic decisions grounded in reality rather than assumptions.
Real-world examples continually illustrate the consequences of neglecting robust valuation.
Financial crises and bankruptcies often result from overvalued acquisitions, inflated asset
prices, or underappreciated risks—mistakes that proper valuation could have detected. During
economic downturns or market shocks, the failure to realistically appraise distressed
businesses can lead to poor investment choices, suboptimal restructurings, and loss of
stakeholder value.
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In essence, robust valuation is the compass by which financial professionals, companies, and
investors navigate a world characterized by uncertainty, competition, and continuous change.
Whether it is supporting capital allocation, underpinning strategic growth, or confronting the
complexities of financial distress, the real-world need for valuation remains both immediate
and indispensable.

1.4 Overview of Elite Valuation

Elite Valuation stands as one of India’s foremost professional valuation and transaction
advisory firms, headquartered in Ahmedabad. Recognized by key regulatory bodies—
including registration as a Category-I Merchant Banker with SEBI and as a Registered Valuer
Organization under the Insolvency and Bankruptcy Board of India (IBBI)—the firm offers a
comprehensive suite of valuation services. Its client base ranges from corporates and private
equity funds to family offices, insolvency professionals, and regulators.

The firm’s expertise spans a wide spectrum:

 Valuations under the Insolvency and Bankruptcy Code (IBC)
 Regulatory valuations in accordance with SEBI, RBI, and the Companies Act
 Fairness opinions and financial reporting valuations
 ESOP and startup valuations
 Litigation, arbitration, and M&A support
 Financial modeling and forensic valuations

Elite Valuation has successfully delivered over 500 mandates across a breadth of industries,
including real estate, manufacturing, fintech, infrastructure, logistics, and healthcare. The
firm is distinguished by its technical depth, unwavering regulatory compliance, and its
nuanced understanding of sector-specific challenges.
During my three-month internship at Elite Valuation, I was immersed in live valuation
engagements that exposed me to real-world business complexities, particularly those
involving distressed and underperforming companies. This hands-on experience allowed me
to observe and participate in how valuation theory is dynamically adapted and rigorously
applied in practice.

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1.4.1 My Learning Journey at Elite Valuation

 Over the course of my internship, I gained practical exposure in several critical areas:
 Applying the Discounted Cash Flow (DCF) method for valuing both stable and
distressed businesses.
 Utilizing Relative Valuation methods by benchmarking market multiples across
sectors.
 Employing the Venture Capital Method to assess startup valuations.
 Understanding and implementing the Cost Approach, Market Approach, and Income
Approach, all in line with International Valuation Standards (IVS).
 Building and refining financial models, performing scenario and sensitivity analyses,
and modeling valuation outcomes in Excel.
 Navigating the intricacies of regulatory frameworks, such as the IBC, Companies Act,
and FEMA, and understanding their impact on valuation practices.
 This experiential learning was pivotal in shaping my research direction. Being part of
complex valuation projects gave me firsthand insight into the specific hurdles
involved in assessing underperforming and distressed firms—a perspective that
directly inspired the focus of this report.

1.5 The Dark Side of Valuation: Defining Distressed and Underperforming
Companies

1.5.1 Dark side of Valuation

I have always believed that valuation is simple and that we, its practitioners, choose to make
it complex. The intrinsic value of a cash flow-generating asset is a function of how long you
expect it to generate cash flows, as well as how large and predictable these cash flows are.
This is the principle that we use in valuing businesses, private as well as public, and in
valuing securities issued by these businesses. Although the fundamentals of valuation are
straightforward, the challenges we face in valuing companies shift as firms move through the
life cycle. We go from idea businesses, often privately owned, to young growth companies,
either public or on the verge of going public, to mature companies, with diverse product lines
and serving different markets, to companies in decline, marking time until they are liquidated.
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At each stage, we are called on to estimate the same inputs—cash flows, growth rates, and
discount rates—but with varying amounts of information and different degrees of precision.
However, this is where the dark side of valuation often emerges. When confronted with
significant uncertainty or limited information, many valuators stray from the discipline of
fundamentals. They abandon first principles, invent new paradigms to justify unrealistic
assumptions, and, in the process, let go of common sense. The dark side of valuation, thus,
refers to this deviation from core valuation logic in Favor of narratives or models that may
look sophisticated but lack grounding in reality.

1.5.2 Distressed Companies

 Definition: Companies under severe financial, operational, or legal pressure—often

unable to meet debts or facing insolvency procedures.
 Key Challenges in Valuation:
 Traditional methods assume the business will continue, but distressed firms
may shut down or liquidate.
 Default risk, ongoing losses, or bankruptcy filings make future cash flows and
terminal value highly uncertain.
 Common Signs:
 Loan defaults, negative cash flows, emergency asset sales, court-led
restructuring.
 Example: An airline filing for bankruptcy protection—market value collapses, assets
may be sold at “fire-sale” prices instead of business continuing.
 Practical Adjustment: Analysts may use liquidation value (the worth of assets if sold
piecemeal), scenario analysis, or raise discount rates significantly to account for risk.
1.5.3 Underperforming Companies

 Definition: Firms that continue operating but fall behind industry averages or show
deteriorating fundamentals over time.
 Key Challenges in Valuation:
 Earnings and cash flows are inconsistent and may shrink; predicting future
performance is tough.
 Industry benchmarks may not be appropriate—peer companies might be much
healthier or also struggling.
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  Symptoms:
 Flat or declining sales, below-average profit margins, outdated product lines,
inefficient operations.
 Example: Traditional retailers losing ground to online-only competitors; telecom
operators unable to match digital newcomers.
 Practical Adjustment: Discount cash flow projections are reduced, growth
assumptions tempered (often set to zero or negative), and peer comparisons adjusted
for lower performance.
1.5.4 Why These Firms Embody the “Dark Side”

 Input Sensitivity: Small changes in projections (like growth or margins) can

drastically swing the valuation outcome.
 Data Issues: Market-based multiples may be useless or misleading; financial reporting
may be unreliable in troubled companies.

 Survival Uncertainty: There may be a real possibility the company ceases to exist, so
standard valuation approaches need to be modified or replaced with scenario/survival
models.
 Analyst Judgment: More than ever, experienced judgment and sceptical thinking are
required—there’s no “one right answer,” just a range of outcomes based on
probabilities.
Real-World Briefs for Each:
 Distressed - A steel mill missing bank loan payments, entering court-led insolvency
where assets might only fetch scrap value.
 Underperforming - A legacy auto parts company consistently earning returns below
its cost of capital while industry shifts to electric mobility.

1.6 why I Chose This Topic

I chose to focus on valuation because it is a very important part of finance and business
today. With businesses facing so many ups and downs—like economic problems, rule
changes, and events like the COVID-19 pandemic—knowing the actual value of a company
or asset has become even more necessary.

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Valuation helps people decide if an investment, a business deal, or a company is a good one
or not. It is used by many people, like investors, business owners, and financial advisors, to
make smart decisions and avoid mistakes.
Sometimes, when a company is facing trouble, it becomes even harder to know what it is
really worth. Regular methods might not work well during these tough times, so learning
about valuation helps to find better ways to get the true value.
By studying this topic, I hope to understand how financial experts and professionals do
valuations, and how their methods can help avoid problems and make better choices in
business.

1.7 Relevance of the Topic

The relevance of valuation today is underscored by the profound shifts and instability seen
across financial markets in recent years. As economic turbulence, regulatory changes, and the
aftermath of the pandemic continue to affect businesses, precise valuation has evolved from a
routine calculation into a critical strategic function. This section explores why valuation,
especially of distressed and underperforming firms, is both timely and practically significant.

1.7.1 Rise in Financial Distress Post-Crisis

In the wake of the COVID-19 pandemic, subsequent inflation, and tighter monetary policies,
many companies—particularly small and mid-sized firms—have been left exposed to serious
financial challenges. These businesses face falling revenues, mounting debt, and
unpredictable cash flows. As valuation expert Aswath Damodaran highlights, financial
distress is more widespread than typically acknowledged and must be directly addressed
within modern valuation practices. Ignoring the specific risks and real chances of failure in
today’s climate can result in misleading valuations and poor investment outcomes.

1.7.2 Challenges with Traditional Valuation Approaches

Standard approaches—such as the Discounted Cash Flow (DCF) model—generally rely on

assumptions of ongoing growth and stable operations. For troubled firms, these assumptions
do not hold. According to Damodaran and supporting academic resources, using conventional
models can greatly overstate a distressed firm’s actual value, presenting a false sense of
security to investors and managers. This is particularly true in markets like India, where many
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private companies continue to struggle with recovery and transparency following the
pandemic.

1.7.3 Demand for Adaptive Valuation Models

The increasing prevalence of business failures and restructuring has triggered demand for
new, more agile valuation frameworks. Investors and analysts now seek models that
incorporate sector-specific risks, the probability of default, operational uncertainties, and
even incomplete financial data. Hedge funds, private equity groups, and restructuring
advisors increasingly focus on pricing distressed assets accurately—not simply to avoid them,
but to uncover potential opportunities, as recognized in multiple global finance studies.

1.7.4 Real-World Professional Insights

Through direct experience as a valuation analyst—including at specialized firms working

with distressed companies—it becomes evident that practical application often demands more
than textbook approaches. Adaptive strategies such as scenario-based DCFs, liquidation
values, and probability-weighted models are now essential. The real business impact of
accurate valuation is clear: it can determine not only negotiations and restructuring options
but also whether a company finds a new investor or faces liquidation.

1.7.5 Conclusion: Why the Topic Matters Now

In summary, this topic is highly relevant because:

 Distress is widespread: More companies now face uncertainty due to accumulating
debt, inflation, and shifting global dynamics.
 Traditional models are inadequate: There is an urgent need for new approaches better
suited to troubled firms.
 Private companies require special focus: Opacity and inconsistent disclosure demand
specialized tools for fair assessment.
 Professional demand is rising: Regulators, investors, and practitioners seek robust
ways to value challenging assets.
 Modern research bridges theory and practice: New frameworks from thought leaders
like Damodaran offer actionable, real-world solutions.
By studying these issues, the report not only addresses a major academic concern but also

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provides practical guidance for navigating the increasingly complex world of financial
valuation.

1.8 Scope of This Study

This study focuses on:

 Valuing distressed and underperforming companies, particularly in the Indian private
sector context.

 Understanding the limitations of traditional methods like Discounted Cash Flow

(DCF) or Relative Valuation.

 Adapting valuation frameworks based on secondary research, primarily Damodaran’s

theories, to improve accuracy.

 Evaluating companies through models that incorporate risk, default probability, and
sector-specific issues.

The research does not involve any primary data collection, due to confidentiality clauses, but
uses published case studies, academic papers, and real-time exposure gained during the
internship

1.9 Research Methodology Overview

The study uses a qualitative research approach based on secondary sources:

 Books: Damodaran’s “The Dark Side of Valuation” and “Valuing Distressed and
Declining Companies”

 Academic papers, thesis, and white papers

 Case analyses of real-world companies

No fabricated primary data or financial projections are used. Ethical standards for academic
research are strictly maintained.

1.11 Structure of the Report

The full report is organized into the following chapters:

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 Chapter 1: Introduction – Research context, objectives, scope

 Chapter 2: Literature Review – Review of academic and professional frameworks

 Chapter 3: Research Methodology – Approach, data sources, and design

 Chapter 4: Valuation of Distressed Companies – Detailed analysis of valuation

models

 Chapter 5: Case Studies – Real-world application and valuation logic

 Chapter 6: Findings and Discussion – Key insights and professional relevance

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CHAPTER 2: LITERATURE REVIEW

The chapter offers a thorough summary and assessment of global research and literature pertinent to
the topic under study. It offers background information on the topic, including its historical context,
theoretical framework, and foundational concepts or theories relevant to distressed company
valuation. It discusses various methodological approaches used in previous studies, including
research designs, data collection methods, and analytical techniques. This helps inform the choice
of methodology for the current study. This includes seminal works and recent research relevant to
the study which helps to trace the gap in the literature. The chapter ends with the research gap and
the need to address the topic in depth.

2.1. Introduction

The valuation of distressed companies is a crucial aspect of corporate finance and investment
banking. It is a subject of interest for academicians and professionals specializing in turnaround
management, restructuring, and distressed investing. Given the complexities involved in valuing
distressed companies and the significance of this field in corporate finance and restructuring, it is
reasonable to assume that the volume of research on this topic continues to grow. Researchers,
practitioners, and stakeholders continually seek to refine their understanding of valuation
methodologies and adapt to evolving market conditions, making it a dynamic and active area of
research and analysis. Globally, researchers have conducted numerous studies on the topic of
valuation of going concern companies. However, to be precise, the field of valuation for distressed
companies is still understudied in India.
A firm's life cycle consists of four stages: initiation, growth, maturity, and decline as mentioned in
the earlier chapter. During the growth stage, the firm aims to expand its market share by penetrating
new markets and understanding customer needs to provide better goods or services. While firms in
the mature stage benefit from a large market share and diverse product offerings, some struggle to
compete and face financial challenges, eventually entering a decline phase and starting to fade
away. Overall, valuation is of interest to a diverse range of stakeholders involved in investment,
finance, business management, regulation, and advisory services. It serves as a fundamental tool for
making informed decisions, assessing risks, and allocating resources effectively.
All the stakeholders, including shareholders, lending institutions, the government, acquirers,
analysts, valuation professionals, and academicians, are interested in the valuation of the firm at
every stage.
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The literature in the domain of insolvency law has predominantly been contributed by international
researchers, in contrast to Indian scholars. This disparity can be attributed to the relatively recent
establishment of insolvency laws in India. Consequently, the Indian insolvency framework is a less
mature and researched area, resulting in fewer publications from Indian scholars compared to their
international counterparts. Literature has been divided into two categories – International studies
and domestic studies

2.1.1 The Cost of Distress: Survival, Truncation Risk and Valuation (Damodaran, The Cost of
Distress: Survival, Truncation Risk and Valuation, 2006)

(Damodaran, 2006) examined how traditional DCF and relative valuation methods fail to capture
the effects of financial distress. The paper argued that assuming all firms are going concerns
overstates firm value when bankruptcy is possible. The study proposed adjusting valuations by
estimating distress probabilities and expected sale proceeds under failure scenarios. Modified DCF,
simulation models, and adjusted present value (APV) were explored as better approaches. It
emphasized that distress lowers access to capital, inflates discount rates, and causes both direct and
indirect costs, often underestimated. The author illustrated this using Global Crossing, showing how
ignoring distress leads to inflated equity values. He also showed how relative valuation must be
adapted when comparables are also distressed.

2.1.2 Valuing Declining and Distressed Companies (Damodaran, 2009)

(Damodaran, 2009) analysed the challenges in valuing distressed companies using traditional DCF
models. The paper noted that firms in decline often show flat revenues, shrinking margins, and high
debt, making optimistic growth assumptions unrealistic. It introduced a two-factor framework based
on the reversibility of decline and presence of distress. The author criticised “auto-pilot optimism”
shown by analysts while applying sector averages. Adjusted DCF, liquidation value, and control-
based valuation were recommended depending on firm condition. The study suggested using market
value of debt and incorporating distress probabilities. Case studies like Sears and Las Vegas Sands
demonstrated how traditional methods overstate value. The paper highlighted the need for
conservative, scenario-based, and probability-adjusted valuation tools when dealing with financially
troubled firms.

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2.1.3 Valuing Firms Under Default Risk and Bankruptcy Costs: A WACC-Based Approach (Carlo
Maria and Marcella Marrab, 2018)
(Mari and Marra, 2018) addressed the problem of valuing leveraged firms under financial distress,
where traditional DCF and WACC models often ignore the effects of bankruptcy costs and default
risk. The authors proposed a generalized WACC-based valuation framework that integrates one-
period default probabilities, tax shields, and expected costs of bankruptcy. They derived a closed-
form WACC formula that reflects the trade-off between tax benefits of debt and the financial risks it
brings. The model allows for more realistic firm valuation by adjusting the discount rate to reflect
both survival and default scenarios. In high-risk cases, the formula can even generate negative
discount rates, emphasizing the extreme impact of distress. A simulation exercise illustrated how
the model leads to optimal capital structure outcomes depending on debt levels and distress
parameters. This approach bridges a key gap in valuation literature by offering a mathematically
consistent and practically applicable model for firms exposed to default.

2.1.4 Distressed Firm Valuation: Reorganization Plan and Going-Concern Capital Value (Fabio
Buttignon*, December 2014)
(Buttignon, 2014) explored the complexities of valuing distressed firms using a practical framework
based on discounted cash flow (DCF) and option pricing models. The paper emphasized comparing
the going-concern value of a firm under reorganization with alternative scenarios such as asset
liquidation or ownership change. A structured process was proposed: analyzing historical results,
forecasting financials under the reorganization plan, estimating enterprise value (EV), debt (D), and
equity (E), and performing scenario analysis. It highlighted the use of both DCF and Black-Scholes-
Merton (BSM) models to calculate risky debt and shareholder value. The study underlined the role
of negotiation between creditors and shareholders in sharing the benefit of debt restructuring.
Overall, the paper presented a valuation model that balances financial theory with practical
decision-making under distress.

2.1.5 Valuation of distressed companies: Case DIA Group (Jortikka, 2019)

(Jortikka, 2019) analyzed the valuation of distressed firms using a weighted approach combining
going concern value and distress sale value, based on the probability of default. The study
emphasized that traditional DCF models fail under distress due to inflated inputs and overlooked
risks. The author applied a hybrid valuation model to DIA Group, adjusting cost of capital and cash
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flow assumptions

over a 10-year recovery period. Key adjustments included variable WACC, Monte Carlo
simulations, and scenario-based liquidation estimates. The final equity value per share was €0.83,
showing a 20% upside from market price. The research concluded that sensitivity to inputs like
EBITDA margin, revenue growth, and default risk is critical in distressed valuation. The model
proved more reliable than conventional techniques.

2.1.6 Distressed Assets as Investment Opportunity for Private Equity (Tara Rožman (2017), Feb ,
2017)
(Rožman, 2017) examined how distressed assets can create value opportunities for private equity
investors during post-crisis restructuring. The thesis outlined how Slovenian companies became
highly indebted due to excessive pre-crisis borrowing, worsened by the global financial crisis and
withdrawal of bank lending. The study analyzed the formation of BAMC and the role of
government in transferring non-performing loans to stabilize the banking system. The author
proposed that private equity funds using turnaround strategies could capitalize on undervalued firms
through operational restructuring and strategic exits. A multi-stage filtering of 575 companies led to
identifying viable targets based on financial metrics, industry potential, and business model
strength. The thesis concluded that despite debt overhang, distressed firms with competitive
advantages could offer high returns under effective ownership and strategic revival.

2.1.7 Valuing Companies with intangible assets (Aswath Damodaran, sept 2009)
(Damodaran, 2009) examined the challenges of valuing firms where intangible assets like brand
value, human capital, and R&D dominate the balance sheet. The paper highlighted that accounting
standards often misclassify intangible investments as operating expenses, leading to distorted
income statements, undervalued asset bases, and misleading profitability ratios. The author
proposed capitalizing intangible expenses such as R&D, training, and advertising to adjust earnings,
return on capital, and invested capital. He also emphasized adjusting valuation models to account
for stock-based compensation, using option-pricing models like Black-Scholes. Case studies,
including Amgen and Coca-Cola, demonstrated how restated financials led to more accurate DCF
valuations. The study concluded that ignoring intangibles results in flawed valuations, and analysts
must modify inputs to reflect the true value drivers of such firms.

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2.1.8 Value Creation and the Entrepreneurial Business (Michael F. Spivey & Jeffrey J. McMillan,
2002)
(Spivey and McMillan, 2002) investigated the challenge of measuring value creation in small,
entrepreneurial firms where market-based valuation is unavailable. The study focused on correlating
non-market financial metrics with shareholder return in companies under $100 million in assets. It
evaluated 13 performance indicators across three categories: profitability, cash flow, and growth.
Results showed that profitability metrics like ROE, ROA, and ROIC had strong correlations with
shareholder return, but only for firms with positive earnings. Cash flow metrics were not
significantly linked, while growth measures like EPS and sales growth showed strong predictive
power for both profitable and loss-making firms. The authors highlighted that sales growth was the
most consistent value driver, suggesting it as a reliable proxy in entrepreneurial valuation when
market prices are missing.

2.1.9 The Valuation of Distressed Companies — A Conceptual Framework (Michael Crystal QC*
and Rizwaan Jameel Mokal, 2006)
(Crystal and Mokal, 2006) proposed a conceptual framework for valuing financially distressed
firms, focusing on reorganizations under UK law. They distinguished financial from economic
distress and emphasized that going concern value matters only in the former. The study identified
valuation challenges arising from strategic bias, creditor conflicts, and market illiquidity. It
recommended triangulating value using DCF, comparable, and precedent transactions. The
MyTravel Plc case showed how overreliance on liquidation distorted valuation and creditor rights.
The authors argued that courts often misapply economic interest tests and fail to reflect real
economic value. They concluded that distress valuation demands structured analysis, not
mechanical rule-following.

2.1.10 Valuation of Financially Distressed Firms (Mads Klarskov Wøidemann & Peter Willemoes
Helms, 2017)
(Wøidemann and Helms, 2017) examined the valuation of Sears during financial distress, showing
how traditional models overestimate value due to auto-pilot optimism. Using DCF, relative, and
liquidation methods with restated financials, the study found Sears was undervalued by up to
29.6%, though liquidation indicated no recovery for shareholders. The authors concluded that
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distress must be explicitly accounted for to avoid mispricing and that downside risk is essential in
fair valuation.

2.1.11 Valuation of Financially Distressed Firms (Wøidemann and Helms, 2017)

(Wøidemann and Helms, 2017) examined how traditional valuation methods fail in distressed firms
like Sears. They highlighted that analysts often use overly optimistic inputs, ignoring financial
decline. The study applied DCF, relative, and liquidation models with restated financials. Findings
showed Sears was undervalued, though liquidation gave no equity recovery. The authors stressed
the need for distress-adjusted, scenario-based valuation techniques.

2.1.12 A Study on Financial Distress of Select Companies of Cement & Refineries Industries in
India (Dr. P.R. Venugopal, Dr. Sreemathi Raghunandan, Ms. Sreedevi Chunchu, 2024)
(Venugopal et al., 2024) examined financial distress in 10 listed Indian firms using the Altman Z-
Score model. The study found that 70% of companies were in the safe zone, while others showed
volatility, especially during COVID-19. Regression and ANOVA confirmed significant variation in
Z-Scores among fertilizer firms but uniformity in refinery firms. The study stressed that weak
working capital and EBIT contribute to distress. It recommended asset sales, operational efficiency,
and margin improvement to prevent insolvency.

2.1.13 Relative Valuation of Private Held Companies: Valuation Multiples in the Czech Brewing
Industry (Michal Drábek*, 2022)
(Drábek, 2022) developed industry-specific valuation multiples for private Czech breweries using
DCF as a base. Due to lack of market data, he derived relative valuation indicators like
EV/EBITDA, P/E, and P/S ratios from financials of top 50 companies. EV/EBITDA showed the
least volatility and was found most reliable. Compared to European listed firms, Czech private firms
had significantly lower multiples. The study confirmed that applying listed-company multiples to
private firms may cause major overvaluation.

2.1.14 Turnaround strategies in financially distressed times (Nicolaas Beute, 2018)

(Beute, 2018) investigated how operational, asset, and financial restructuring impact recovery from
financial distress using Altman’s Z”-score across EU firms. The study found operational
restructuring—especially reducing costs and optimising working capital—as the most effective in
20
improving financial health. Financial and asset restructuring showed mixed results, with minimal
impact. The thesis stressed private, informal strategies over formal bankruptcy routes. Findings
suggest that cost control and operational efficiency drive successful turnarounds.

2.1.15 Turnaround Financing: Legal and Financial Considerations for Distressed Companies (Shem
and Mupa, 2024)
(Shem and Mupa, 2024) explored turnaround financing as a recovery tool for distressed firms,
highlighting financial, legal, and stakeholder dimensions. The paper identified insolvency, liquidity
traps, and mismanagement as major risks. It emphasized innovative financing methods like DIP
financing, crowdfunding, and private equity. Legal frameworks, creditor rights, and stakeholder
negotiations were crucial for successful restructuring. Valuation challenges included cash flow
unpredictability, calling for scenario-based DCF and APV models.

2.1.16 Distressed Firm Valuation: A Scenario Discounted Cash Flow Approach (F. Buttignon,
2020)
(F. Buttignon, 2020) Proposes a scenario-based DCF model tailored for advanced-stage distressed
firms, integrating the option to liquidate and emphasizing the importance of scenario analysis in
capturing the uncertainty and restructuring needs of distressed companies.

2.1.17 On the Valuation of Distressed Firms: A Conceptual Framework and Case Application (S.
Afflerbach , 2014)
(Afflerbach, 2014) introduced a model that adjusts traditional valuation methods for distressed firms
by factoring in default probability. The study emphasized that DCF, relative, and liquidation
approaches overvalue declining firms if default risk is ignored. Using Eastman Kodak as a case, the
model applied a probability-weighted average of going concern and liquidation values. The default
risk was derived using Black-Scholes-based Distance to Default. The study concluded that scenario-
based, risk-adjusted frameworks yield more realistic valuations in distress settings.

2.1.18 Corporate Financial Distress Prediction in a Transition Economy (M. Nguyen et al., 2023 )
(Nguyen et al., 2023) predicted financial distress in Vietnam using five models: LDA, logistic
regression, SVM, neural networks, and the Merton model. The study tackled imbalanced data using
SMOTE and found neural networks as the best performer in balanced accuracy. Combining
Altman’s and Ohlson’s variables gave stronger predictive results than using either alone. Market-
21
based Merton model underperformed due to Vietnam’s inefficient stock market. The authors
emphasized customizing distress models to local data rather than applying coefficients from
developed economies.

2.1.19 Evaluation of Claims on Distressed Firms: A Conceptual Framework (J. K. Müller, 2018)
(J. K. Müller, 2018)Develops a 10-step framework for evaluating claims on distressed firms,
advocating for structural models based on option pricing to better capture the uncertainties and
bankruptcy priorities compared to traditional methods; applies the framework to Air Berlin.

2.1.20 Deep Learning-Based Model for Financial Distress Prediction (M. Elhoseny et al., 2022 )
(M. Elhoseny et al., 2022 ) Presents a deep learning approach using adaptive whale optimization for
financial distress prediction, achieving high accuracy and demonstrating the effectiveness of
machine learning for early warning in distressed firm contexts.

2.1.21 Distressed Firm Valuation: Reorganization Plan and Going-Concern Capital Value
(Buttignon, 2015)
(Buttignon, 2014) proposed a comprehensive valuation framework for distressed firms, integrating
DCF and option pricing models. He emphasized adjusting for distress through scenario-based
forecasts, restructured balance sheets, and capitalized risk. The paper introduced both DCF and
Black-Scholes-Merton models to value risky debt, highlighting the “put option” benefit for
shareholders from creditor concessions. Equity value was shown to emerge from EV minus reduced
debt value post-restructuring. The study stressed that valuation in distress must align with creditor
approval and legal-economic realities to be actionable.

2.1,22 Industry Specific Financial Distress Modeling (N. Sayari, H. Simga-Mugan, 2017 )
(Sayari & Mugan, 2017) developed industry-specific distress models by combining factor analysis,
entropy methods, and logistic regression across S&P 1500 firms. The study revealed that financial
ratios carry different predictive power across industries, requiring tailored models. By identifying
the most informative ratios for each sector, they improved accuracy in forecasting distress. The
entropy technique was used to reduce uncertainty and select high-information variables. The
findings emphasized that generic models often fail, and sector-focused models significantly enhance
22
distress prediction.

2.1.23 Predicting Financial Distress and the Performance of Distressed Stocks (J. Y. Campbell, J.
Hilscher, J. Szilagyi, 2011)
Develops a model combining accounting and market-based measures to predict distress, showing
that distressed stocks underperform despite high risk, with implications for valuation and
investment decisions.

2.124 A Systematic Review of Models for the Prediction of Corporate Insolvency (N.
Sathyanarayana, R. Narayanan, 2024)
(N. Sathyanarayana, R. Narayanan, 2024) Surveys recent bankruptcy prediction models for Indian
listed firms, covering statistical, machine learning, and hybrid techniques. Finds that models
incorporating macroeconomic and industry-specific variables provide better early warning signals
for insolvency, but notes challenges with qualitative data integration and sample limitations.

2.1.25 Private Equity and Financial Distress: A Bibliometric Literature Review (M. D. Boubaker,
M. Nguyen, 2024)
(M. D. Boubaker, M. Nguyen, 2024) Examines the impact of private equity on portfolio companies’
financial distress, mapping research trends and identifying key themes. The review suggests that
private equity involvement can both mitigate and exacerbate distress risk, depending on leverage
structures and market conditions.

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CHAPTER 3: RESEARCH METHODOLOGY

This study adopts a qualitative research approach based entirely on secondary data. No primary
data was collected; instead, the research draws from books, academic articles, case studies, and
expert insights—primarily from Professor Aswath Damodaran’s work on valuation. A case study
methodology is used to analyze how traditional valuation models are applied to distressed and
underperforming companies. The objective is to interpret established theories in real-world
contexts using documented evidence. This method ensures depth and reliability without direct
fieldwork.

3.1 Research Design

The research follows a qualitative and descriptive design, aimed at understanding the complexities
of valuing distressed and underperforming companies. Instead of collecting primary data, the study
relies on secondary sources, including valuation books, academic research papers, industry reports,
and real-world case studies.
A case study approach has been adopted to examine how traditional valuation methods—such as
Discounted Cash Flow (DCF) and Relative Valuation—are adapted in distressed scenarios. This
design allows for in-depth analysis and contextual interpretation of valuation challenges and
strategies, based on documented examples and expert literature.

3.2 Research Objective

The primary objective of this study is to understand how valuation methodologies are adapted or
challenged in the context of distressed and underperforming companies, particularly when
traditional models such as Discounted Cash Flow (DCF) or market multiples prove inadequate.
These companies deviate from standard valuation assumptions, such as consistent positive cash
flows, access to capital markets, and long-term growth potential.
Given the increase in corporate defaults, NPA events, and insolvency proceedings under
frameworks like India’s IBC 2016, it becomes essential to revisit and reframe the valuation
approaches that can be used in such contexts. This research draws heavily from the secondary
academic and professional literature to develop a conceptual understanding of valuation techniques
in such cases.

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Specific Objectives:
 To examine the conceptual foundations of valuation when applied to distressed companies.

 To critically assess the strengths and weaknesses of traditional methods (DCF, Relative, and
Asset-based Valuation) under financial distress.

 To study frameworks proposed by Aswath Damodaran, including the expected value

approach that blends going concern and liquidation scenarios.

 To compile and analyze documented case studies from previous research and published
sources.

 To explore how valuation inputs like discount rates, terminal values, and cash flows are
altered in the presence of distress signals.

3.3 Methodological Framework

This study uses a conceptual framework approach, inspired heavily by Aswath Damodaran’s books
and articles, especially:
 The Dark Side of Valuation

 Valuing Distressed and Declining Firms

 Damodaran’s valuation lectures, notes, and academic publications (available through NYU
Stern)

Other secondary references include:

 Master's thesis reports

 Industry white papers by McKinsey, PwC, and EY

 Valuation models published in Shodhganga, SSRN, and academic journals

Rather than proposing a new valuation model, this research integrates best practices and theoretical
insights to analyze what makes valuation in distress cases uniquely challenging, and how to
approach it with conceptual clarity.

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3.4 Data Collection Method

This study is entirely secondary in nature. All data used for analysis and argument construction is
obtained from publicly accessible and academically reliable sources. No surveys, interviews, or
company-specific private datasets have been used.
Sources of Data Include:
A. Academic Texts and Research
 Damodaran, A. (2009, 2016, 2018): Valuation theory, distress frameworks

 Afflerbach, S. (2014): Case study on Kodak

B. Published Company Data

 Financial statements, annual reports (used illustratively)

 Bankruptcy filings and CIRP documents (used for contextual reference only)

C. Regulatory and Industry Reports

 Insolvency and Bankruptcy Board of India (IBBI)

 SEBI and RBI publications

The information has been referenced in accordance with academic citation standards to ensure
research integrity.

3.5 Analytical Tools and Conceptual Models

As this study is based on theoretical frameworks and secondary data, the following valuation tools
and models are used illustratively and analytically:

3.5.1 Discounted Cash Flow (DCF) – Distress-Adjusted

 Modified discount rate to include default risk

 Terminal value with zero or negative growth assumptions

 Use of scenario-based cash flow forecasts

3.5.2 Expected Value Framework (Damodaran)

Firm Value = (1 - pd) × Going Concern Value + pd × Liquidation Value

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Where:
 pd is the probability of default

 Liquidation value includes adjusted recovery value

 Going concern assumes turnaround potential

This blended model helps handle uncertainty and integrates risk-adjusted cash flow valuation.

3.5.3 Relative Valuation Under Stress

 Adjusted EV/EBITDA and P/B multiples

 Peer comparison with other distressed firms

 Consideration of control premiums or distress discounts

3.5.4 Risk and Insolvency Models

 Altman Z-Score (for assessing distress)

 Credit spread approaches for cost of capital estimation

 Legal status and CIRP stage as qualitative modifiers to valuation

3.5.5 Scenario & Sensitivity Analysis

 To illustrate how valuation varies across assumptions

 Demonstrates how input volatility impacts enterprise value

 Three-stage scenario reference: Best, Worst, Realistic (conceptual only)

3.6 Scope and Limitations

Scope:
 Focused on understanding the valuation of distressed and underperforming companies

 Includes only secondary data and published research

 Emphasizes Indian context, but draws from global research (especially Damodaran)

 Integrates academic and professional valuation frameworks

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Limitations:
 No original empirical data or primary interviews

 Relies on available case studies, which may not fully represent all sectors or time periods

 Illustrative use of data (e.g., financials, Z-scores) and not predictive modeling

 No direct access to proprietary valuation models or confidential restructuring documents

3.7 Ethical Considerations

 No primary data was fabricated or manipulated

 All literature and secondary sources are acknowledged and cited

 No confidential data or insider financials were accessed

 The report complies with academic integrity standards of a SIP report

3.8 Summary

This research methodology is rooted in conceptual exploration using trusted secondary sources and
academic literature. By focusing on the works of valuation thought leaders—most notably Aswath
Damodaran—and analyzing how traditional models are adjusted or fail in distressed contexts, the
study aims to contribute meaningfully to the domain of valuation education and professional
practice.
This methodology not only aligns with the objectives of the SIP report but also mirrors the actual
practices and thought processes used by registered valuers and professional advisors when dealing
with companies in financial distress.

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CHAPTER 4:

4. Decline and Distress

It is important to recognize that not every company experiencing decline is necessarily distressed,
and vice versa. However, there is often a close relationship between the two. Both decline and
distress can occur in various stages, each affecting the organization differently—ranging from
relatively minor financial hiccups, like temporary cash shortfalls, to more serious threats, including
near-bankruptcy situations. These challenges impact a firm’s daily operations and, ultimately, its
overall value.
In this section, I will outline the key characteristics of companies that are in decline, as well as those
that are distressed. The discussion begins with the features that typically define a declining
company, supported by a brief analysis of the main causes and possible outcomes of decline. Next, I
will describe the distinct types of distress firms might encounter. The section will also introduce
strategies that organizations can use to address both decline and distress.
Finally, I will clarify which aspects of decline and distress are most relevant to the scope of this
study, setting the stage for a focused and practical analysis.

4.1 Decline

Throughout a company's life cycle, those in the growth phase constantly strive to innovate so they
can keep growing and avoid entering maturity. Mature companies, on the other hand, focus on
prolonging their maturity as long as possible to prevent sliding into decline. Some companies, like
Coca Cola, have managed to stay in their maturity phase for decades, but many eventually start
declining. This decline doesn’t happen for just one reason; instead, it’s usually caused by several
factors working together at the same time. Often, a company enters decline when industry
conditions change, such as when new substitutions appear or technology advances. Sometimes,
human factors are responsible—like management making mistakes, not coming up with new
products, or not seeing shifts in the market or what consumers want [Grant, 2010]. Additionally,
external problems—such as a weak economy or poor capital markets—can make things worse. In
the end, all these factors impact the company’s sales, so as sales fall, cash flow drops and the
company’s performance suffers. At first, the difference between stages is small, but as time passes,
the signs of decline become more obvious. While not every situation is the same, companies in

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decline typically face the following issues [Damodaran, 2009]:
 Stagnant or declining revenues: A company that can’t grow its revenue over a long period
—despite a good market—shows a clear sign of decline.

 Shrinking or negative margins: Often, stagnant revenues are paired with falling profit
margins. This happens as the company loses its power to set prices, so it must lower prices
just to keep revenue from dropping further.

 Asset divestitures: As debt grows, declining companies often feel pressure to sell off assets
to keep up with loan payments. Plus, assets might not be used well, so selling them becomes
logical.

 Financial leverage: When revenue and profits fall, it becomes harder to keep up with
financial obligations. The risk rises, making it tough to get new loans because the
company’s borrowing costs increase, closing off opportunities to raise capital.

 Liquidity constraints: As revenue drops and working capital needs rise, the company’s free
cash flow shrinks, making it harder to stay liquid.

From the start, these problems can be tackled by mature companies with healthy finances, but as
things get worse, it becomes harder to solve them. If not addressed, these issues shift from strategic
to financial problems, like being short on cash or struggling with debt. Responses to decline can
involve both strategy and finance, but the deeper the decline, the more the response focuses only on
financial survival. Companies facing all these issues must first stabilize their finances before they
can fix the underlying strategic problems [IDW, 2012] , [Grant, 2010]. This study examines firms
facing all these challenges—firms that can keep operating for a while but face the real risk of
bankruptcy. Although these companies have the possibility of turning things around, if nothing
changes, they’re likely to go bankrupt or get liquidated.

2.2 Distress: Financial and Economic

There are two broad types of distress: economic distress and financial distress. When a company is
mature, most of its value comes from investments that drive growth. By contrast, a declining
company gets almost no value from new investments and mainly relies on its existing assets. In
some cases, new investments actually destroy value because the returns are less than the company’s
cost of capital. When this happens, the company’s net present value as a going concern drops below
the value of its assets alone, which means the business isn’t truly viable anymore—in academic
terms, it’s “economically distressed.” In this state, assets aren’t being used as well as they could be,

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so it would be better for the company to close and sell its assets instead [Crystal and Mokal, 2006]
[Damodaran, 2009].
However, this is different from financial distress. A financially distressed company might still have
a profitable business model, but can’t pay its bills on time, such as interest or other obligations—a
problem known as illiquidity. The business itself may be sound, and its assets may be in their best
use, but the challenge is simply cash flow. If a company can’t pay its debts, it may have to sell
assets at a loss to cover loans, often leaving no value for shareholders.
Financial distress goes beyond just the cost of selling assets. The company’s bad reputation can hurt
operations—employees leave, customers are lost, and suppliers or lenders become wary of doing
business. Research by Andrade and Kaplan (1998) found that these indirect costs can add up to
10%–23% of the firm’s total value [Andrade and Kaplan, 1998]. Such a large impact can
significantly lower the value of a distressed company.
For companies in economic distress, unless changes are made, they will eventually fall into
financial distress. This study focuses mainly on companies in financial distress but which are still
viable businesses—that is, the possibility of bankruptcy is high, but not certain or immediate.
2.3 Strategies for Declining and Distressed Companies
Companies facing decline and distress have several possible strategies to choose from. Which
strategy best depends on the company’s economic health and future viability. Often, this decision
creates tension between shareholders and lenders: once debt is higher than equity, shareholders
usually won’t get anything if the company is liquidated, so they may take bigger risks trying to
recover. Lenders, however, prefer less risk to protect their chance of repayment. Typically, the
company draws up a restructuring plan, including a full valuation, to see what’s possible. Based on
the results, it may choose from these options:
 Liquidation

 Divestment

 Restructuring

Liquidation: If the company isn’t likely to survive, the traditional path is to sell all assets (divest)
or try to get as much cash as possible from what it already has, without investing in anything new
(harvest). The choice depends on whether the company can still extract any value from its assets; if
it can, harvesting is preferred, but if the market or industry is unprofitable, liquidation is usually
better. Sometimes, if things are especially bad, liquidation is forced by lawsuits from creditors. Both
strategies assume the industry itself isn’t profitable. But if there’s potential for profit, other
strategies might be worthwhile [Grant, 2010]. If liquidation is chosen, company value is typically

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assessed using the liquidation approach.
Divestment: Selling some or all company assets can also be a good move in distress or decline.
Partial sales are often central to a company’s turnaround efforts, helping to put the company on a
better strategic footing and providing much-needed cash. Other options include selling the company
or merging with a partner—often to improve competitiveness by combining strengths.
Restructuring: If parts of the company still have value, restructuring can help restore financial
health. Usually, shareholders prefer this to liquidation, though lenders may not because it carries
risk. Restructuring assumes that sales and profit margins will improve and eventually reach the
industry average. If restructuring goes well in the first five years, the company’s survival becomes
likely, and the bankruptcy risk gradually disappears.
The choice between these paths depends on the company’s financial shape. When things are truly
dire, creditors may force liquidation. As things improve, other options are possible. This study
mainly looks at valuing companies during restructuring, aiming for a model that helps decide wisely
between divestment, liquidation, and restructuring.
2.4 Scope of this Study
As discussed, decline and distress often go together. This study, though, does not focus on
companies that have just mild financial distress—like firms with temporary cash flow problems
even though they’re otherwise profitable. The main focus is on companies with dropping revenues
(i.e., negative growth) and financial troubles caused by that negative growth. It’s important to note
these aren’t bankrupt firms; instead, they face possible bankruptcy if their finances don’t get better
in the medium term. Therefore, throughout this study, “distress” and “decline” are used to describe
companies with all these traits. Specifically, they are firms that have rapidly falling sales and
smaller profits, and that now face the risk of not being able to pay interest or meet other financial
obligations in the future.
3 Traditional Valuation Methods
The academic world gives us lots of studies and articles that talk about different ways to value a
business. At the same time, there are plenty of articles focusing on companies that are struggling,
facing financial trouble, or at risk of going bankrupt. But, there really aren’t many research papers
that bring these two topics together—meaning, very few studies actually talk about how to value
companies that are in decline and are distressed at the same time.
Some of the most important work on this subject are actually chapters found in big books about
valuing companies or bankruptcy. For example, writers like Damodaran (2009), Arzac (2008), and
Scarberry (1996) have all covered this topic [Damodaran, 2009][Scarberry et al., 1996]. Besides
these, there is also a major area of research in accounting. Here, researchers study the difference

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between the value shown in company books (book value) and the amount investors are willing to
pay in the market (market value), especially for companies that are losing money [Collins et al.,
1999][Hsu and Etheridge, 2009].
Although there are hundreds of methods to figure out the value of distressed companies, in this
study, we are looking at just the traditional valuation techniques. We’re focusing on these main
ways:
 Intrinsic Valuation: Looks at the company’s own cash flows and future possibilities.

 Relative Valuation: Compares the company to others, often using ratios or market
multiples.

 Option Pricing Valuation (Asset-Based Valuation): Values the company based on its
assets and sometimes uses option pricing models to handle risk.

These three methods can give very different values for the same asset, even at the same time.
Depending on what type of company it is, and its special situation, one method might work better
than others—but usually, people use them together to get a clearer answer. All these traditional
valuation methods can also be used for companies in trouble, but each of them has serious
downsides as well. The biggest problem for all traditional methods when dealing with distressed
companies is that they all assume the company is going to continue forever. For example, both
discounted cash flow and relative valuation use something called Terminal Value, which assumes
that any financial trouble is only for a little while and that the company will not close down in the
future. Still, this assumption..

Figure 1: Valuation methods

completely neglects the risk of bankruptcy and the possibility that the firm
might liquidate and cease to exist. While there is a chance that the firm

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will manage to return to financial health, in a distressed scenario there is
a significant risk that the expected future cash flows to the firm truncate
because of bankruptcy or liquidation. Neglecting this risk in a valuation can
severely overestimate the value of the firm. Moreover, including this risk in
traditional valuation approaches can be very challenging.
While a full analysis of the traditional valuation methods is beyond the
scope of this study, the following section will briefly analyse the problems of
traditional valuation techniques in a distressed company scenario and high-
light possible adaptations to account for the risk resulting from distress.
Therefore, the three different approaches, namely intrinsic valuation, rela-
tive valuation and contingent claim valuation, will be presented and their
applicability and limitations in valuing distressed companies in relation to
the proposed model will be explained.
3.1 Intrinsic Valuation: DCF Method
The intrinsic value of an asset is the fundamental, theoretically-true value of an asset. It is normally
estimated on the basis of its cashflows, growth potential and risk. Although multiple models to
determine the intrinsic value exist, this study will focus on the most commonly used, namely the
Discounted Cash Flow (DCF)method. In general, the DCF approach aims to estimate the current
company value based on the present value of the company's projected future cashflows discounted
with an appropriate rate such as the weighted average cost of capital (WACC).
"You can estimate the value of an asset as a function of cashflows generated by that asset, the life
of the asset, the expected growth in cash ows and the risk associated with the cash ows. That
principle remains intact for every business at every point in time, no matter how much uncertainty
there is in the process." Aswath Damodaran.

Although the DCF method is a popular and widely-used method, the problem with its application
lies in the complexity of estimating the different inputs. A firm in financial distress has some or all
of the following problems: negative earnings and cash flow, an inability to meet debt payments, no
dividends, and a high debt/equity ratio. This makes it difficult to apply discounted cash flow
methods to these firms. The solution to the problem depends, to a large extent, on how distressed
the firm really is. If the distress is not expected to be fatal (in the sense of pushing the firm into
liquidation), there are various potential solutions. If, on the other hand, the distress is likely to be
terminal, finding a solution is much more difficult. An investor or analyst has to reliably estimate
the following three aspects which are essential for any DCF analysis:

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  Cash Flow Projections

 Terminal Value

 Discount Rate

Choosing appropriate inputs for the DCF analysis can be difficult. A minor change in any one of
these variables can significantly affect the estimated value of a company. In the case of a company
in decline, this task can be particularly complex due to a number of reasons. The following section
will analyze each part of the DCF method and explain the complexities when applied in a distressed
scenario.
3.1.1 Cash-Flow Projections
The DCF builds on a projection of the company’s future cash flow for a lifespan of up to five years.
For a company in decline this can be particularly difficult because one can normally not rely on the
historical data to make these projections. However, if the restructuring plan makes detailed
assumptions about cash flows during the transition period from distress to financial health, the
discounted cash flow valuation may still be feasible. The accuracy of the value obtained from the
analysis is clearly linked to the assumptions made about the probability of the transition from
distress to health, the length of the transition period, and the projections during the transition period.
On the other hand, many restructuring plans tend to be over-optimistic about the company's
turnaround potential and therefore overestimate future cash flows. In a normal case, the discount
rate adjusts for volatility in the cash flow. However, in the case of a distressed firm there is the risk
that the firm will cease operation and essentially truncate the cash flows before reaching the end of
the projection period. Since the DCF method is designed for healthy and growing companies, it
does not take this risk into account. One possibility presented in the literature to account for this risk
is to adjust the expected cash flows to reflect the likelihood of distress by lowering the expected
cash flows. However, this would assume that in the event of distress the distress sale proceeds
would be equal to the present value of the expected cash flows [Damodaran, 2009]. Furthermore,
this would not truly reflect the actual likelihood of distress but merely reduce the value of the firm.

3.1.2 Discount Rate

Thus, the appropriate discount rate has to be estimated. As previously mentioned, the discount rate
adapts for the volatility in the firm’s estimated future cash flows and discounts them to today's
value. This discount rate is usually estimated using the weighted average cost of capital (WACC),
which represents the return that a hypothetical investor would demand from an investment in the

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company, based in part on the company's relative debt/equity ratio. In other words, it is the average
of cost of debt and cost of equity weighted by the company's debt/equity ratio. There are several
problems when computing the WACC for distressed firms.
When computing the WACC, the main problem is that the presence of high leverage has a strong
impact on both the cost of equity and the cost of debt. The cost of debt normally increases in
relation to the likelihood of distress, as can be seen in the rating for the junk bonds of rated firms.
On the other hand, as the debt/equity ratio increases, the cost of equity also increases, as equity
investors see much more volatility in earnings. Furthermore, when estimating the WACC of
declining companies for a DCF analysis, it must be taken into consideration that their debt/equity
levels do not remain constant over time. Therefore, to avoid biased results from the DCF analysis,
the discount rate needs to be recomputed various times to adapt for this change. This issue is
normally not taken into consideration in the usual DCF method. For highly leveraged firms, the
WACC method will generally result in a very high discount rate, which might undervalue the
company.
In addition, there are considerable estimation issues regarding the cost of debt and equity. Many
models build upon book value weights for debt and equity for computing the cost of capital. While
this may be a very stable and dependable estimation metric, it may lead to meaningless results
because most of the financing was raised when the company was in a healthy condition. Therefore,
it does not reflect the true cost of capital in a distressed scenario, since it tends to underestimate the
cost. On the other hand, when the market interest rate for debt is used, the cost will be skewed
upward, since the market will demand a premium for distress. Furthermore, several academics
[Damodaran, 2009] argue against the use of Yield to Maturity for distressed firms because, by
definition, it is based on promised cash flows rather than on expected cash flows. They argue that to
make up for the difference, a stratospheric yield will be necessary. A possible solution is the use of
Default Spread on Bond ratings. Here again, the question of which instrument truly reflects the risk-
less rate is up for discussion.
The cost of equity for the WACC is normally computed by means of the Capital Asset Pricing
Model. When computing the β for the CAPM, in many cases a regression β is used. However,
regression β, particularly in distress cases, normally tends to lag behind in terms of adjusting for
increased risk of higher leverage, because they are estimated over long periods of time. A
possibility for adjusting for this lagging is the use of unlevered β.
3.1.3 Terminal Value
Finally, the terminal value, which represents the value of the cash flows after the initial projection
period into perpetuity, discounted to today's value, poses a major challenge. Making a good

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estimate of the terminal value is critical since it constitutes a major part of the DCF model. The
impact of the terminal value in a distressed valuation is particularly important because the firm
derives a major part of the total value from the fact that it will exist in the future. The terminal value
is usually calculated by applying the enterprise value multiple approach, the perpetual growth rate
model or the liquidation approach.
Similar to the Relative Valuation, the Enterprise Value multiple approach derives the terminal value
by comparing the firm’s value to the market multiples for comparable firms, such as earnings,
revenue or book value multiples. The idea behind the perpetual growth model is to estimate a
growth rate of the firm’s cash flows that the firm can sustain into perpetuity. The liquidation
approach assumes a liquidation of all the firm’s assets in the terminal year and the terminal value is
derived by estimating the market value for all the assets in the final year. Each of these methods
pose some major difficulties when applied to declining firms and distressed firms.
First of all, when a company has negative earnings some of the enterprise multiples, such as
earnings or EBIT, cannot be used since the model requires positive multiple values. Second, some
firms will never be able to reach the stable growth stage again and will default or be liquidated
before the Terminal Value period is reached. Even if the company is able to survive, there is the risk
that the growth rate will be below inflation, or even negative, and therefore the firm continues to
decline. Third, declining and distressed firms normally have returns that are below their cost of
capital, and there is the risk that they will not be able to improve their situation. In the short run this
scenario has a direct negative effect on the reinvestment rate and the Terminal Value. However, if
the situation is expected to continue into perpetuity, it will increase debt levels and may
consequently cause terminal values to implode.
Lastly, the liquidation value approach can be used to derive the terminal value. However, when
applied conservatively, this metric represents the lower end of the valuation range and will possibly
result in undervaluation.
3.2 Relative Valuation
The relative valuation approach seeks to derive the enterprise value by using market-assigned
prices, relative to the earning potential of comparable and publicly traded companies, as a
benchmark for valuing the firm. Such a valuation can also be based on market transactions, such as
financial investments or mergers and acquisitions. There are usually two steps in the relative
valuation process. First, a financial performance metric, such as the EBITDA of the company to be
valued, needs to be calculated. Thus, the multiple of a healthy and comparable company's market-
assigned enterprise values, relative to its corresponding EBITDA, must be determined. These two
inputs are then multiplied to arrive at an enterprise valuation estimate of the company to be valued.

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The use of multiples to estimate the value of companies is simple and easy to relate to. In addition,
they are particularly useful when there are a large number of comparable companies being traded on
financial markets and the efficient market assumptions hold. The advantage of using the relative
valuation method is that it is somewhat simpler than the DCF method. On the other hand, it is not as
elegant and rigorous as the DCF, and care must be taken to include only the most appropriate and
relevant comparable firms, since no company is exactly the same in terms of risk and growth
[Damodaran, 1998] [Koller et al., 2005].
The key is to select appropriate multiples and the most representative indications of financial
performance for each particular case. In addition, for distressed companies it is important to decide
which financial period the valuation should be based upon, since extraordinary levels will not yield
an accurate estimate. During the selection of appropriate market multiples, the evaluation of
multiples of comparable public companies and M&A transactions must take the specific risk
characteristics of the subject company into consideration. In the case of a distressed company these
risk factors tend to be greater and of bigger importance. Therefore, when calculating the company's
revenues, earnings and cash flows, the historical levels must often be adjusted to reflect for previous
mismanagement and corrections associated to the restructuring efforts.
In addition, most relative valuation approaches typically assume a normalized level of working
capital, as the multiples themselves are generally derived from healthy public companies with
normal working capital. The problem is that many of the factors that lead to a reliable estimate of
value in the relative valuation method are very difficult to define. This is due to a number of
reasons.
First, the best option for valuing distressed companies would be to only include distressed
comparable firms in the analysis. However, a large pool of comparable firms are needed to make
reliable relative valuation estimates. Identifying firms that are comparable, and at the same time
distressed, can be very difficult. The comparable firm's multiples for distress can be corrected. This
is done by adjusting the multiple values for the default risk, by using rating models for example. In
addition, a subjective discount can be applied to the comparable multiple in order to account for the
risk of distress. An analyst can therefore reduce the healthy firm’s multiple by a certain percentage
to adapt for decline and distress. However, particular care must be taken when choosing the
magnitude of the discount, since no standard approach exists for this practice. When using this
approach, it is recommended that the multiples are used on projected metrics, as it is assumed that
the firm will return to an industry average, making a relative valuation easier.
Secondly, applicability of the relative valuation methods is somewhat constrained if the subject
company is in decline and distress. Because multiples like Price/Earnings and Price/Book ratios

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only work with positive numbers, other methods have to be used, which directly limits the
application base. When valuing distressed companies, depending on their situation, analysts have to
move up the income statement and use the first positive metric they find. Therefore, the use of
revenue and EBITDA multiples is much more frequent when valuing distressed firms.
Thirdly, in some cases there is a reduced control mechanism by the capital markets because highly
distressed firms trade less frequently and, in general, very little analyst coverage is given. The
reduced existence of market forces makes a multiple-based valuation more complex and less precise
[Damodaran, 2009] [Hotchkiss et al., 2008].
All in all, the relative valuation approach can only be used in a distressed scenario when lots of
personal judgement and predictions about the comparable firms is included. This will eventually
lead to biased results owing to the human factor. However, this method is very useful as a
complement to other valuation methods and acts as a control mechanism.
3.3 Option Pricing Valuation
The Option Pricing Valuation approach is based on the Option Price theory introduced by Black
and Scholes (1973). The concept behind the Option Pricing Valuation is based on the idea that
equity has very similar characteristics to a call option on the firm; i.e., equity can be seen as a call
option on the firm's assets, with debt as a strike price. The limited liability feature of equity suggests
that the equity holders have the right, but not the obligation, to pay off the debt holders and take
over the firm's remaining assets. This in turn means that the debt holders and holders of other
liabilities actually own the firm until the liabilities are paid off [Black and Scholes, 1973]. The
characteristic of an option is that it pays off only under certain circumstances.
This approach can be used to value almost any asset that has option-like features, including
companies. In that sense, the equity of a company can be valued as a call option on the company's
assets, with the face value of debt representing the strike price and the term of the debt measuring
the life of the option [Frey and Schmidt, 2009]. The fundamental idea behind using option pricing
models is that discounted cash flow models usually tend to understate the value of assets whose
payoffs are dependent on the occurrence of a certain event. Therefore, a major advantage of this
method is that option pricing models make it possible to value companies that are hard to value,
such as the distressed and declining companies of this research study, whose economic outlook is
normally contingent on certain events.
However, the main problem with the Option Pricing theory is that, by definition, option pricing
models derive their value from an underlying asset. Thus, to conduct an option pricing analysis, a
valuation of the underlying assets has to be performed first. It is therefore an approach that has to be
used in combination with other valuation methods, or by using market values [Damodaran, 2009].

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While the use of Option Pricing theory as a main valuation tool is limited, there are several other
very interesting characteristics that play a role in valuing distressed firms.
One of the most interesting insights in viewing equity as a call option on the firm’s assets comes to
light when valuing highly distressed firms. In an Option Pricing Valuation, the value of equity will
always be positive, even if the value of the firm falls way below the face value of debt. Even if the
firm is considered to be troubled, it will never be worthless. The concept behind this idea is similar
to giving value to a deep-out-of-the money option because of the possibility that the value of the
underlying asset may increase above the strike price or, in this case, above the face value of the debt
before it comes due [Damodaran, 1998]. Therefore, option pricing valuation allows us to take
aspects such as restructuring efforts into account and to assign a value based on their probability of
success.
Finally, using the main idea and concept behind this theory, not only the equity can be derived but
also other variables such as the underlying value of the asset, i.e., the value of its debt and also the
underlying volatility of the assets/firm. The underlying volatility can then be used to determine
other factors, such as the company's probability of default. This concept is based on the Black and
Scholes Options Pricing model and will be explained in more detail when the Adapted Valuation
Model is introduced later [Crosbie and Bohn, 2003].
3.4 Liquidation Approach
There are differing arguments when it comes to using the liquidation approach in valuation, and its
definition as a main method among the traditional valuation methods. However, due to the
important role of this method in the distressed company scenario, and the model of this research
study, the liquidation approach is presented in this section.
In theory, the liquidation value is determined by the difference between the book value of assets
such as the real estate, fixtures, equipment and inventory owned by a company and the market value
they can fetch upon sale. It must be noted that, contrary to a normal sale of the company, intangible
assets are not included in a company's liquidation value.
In general, there are two possible liquidation scenarios. In the case of severe financial distress, the
debt holder can call for forced liquidation through litigation. In this case, operations are
immediately shut down and the company's assets are liquidated in a "fire sale." In this scenario the
company is only able to fetch a distressed price due to the lack of bidders in the auction process.
In the other situation the company is not in immediate distress but the liquidation value is just
higher than the aggregate future income or free cash flow to the firm. In this case the company can
be liquidated in an orderly fashion. Here the company has enough time to maximize the proceeds of
its assets via an orderly liquidation. Additionally, the business can still generate income while its

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orderly liquidation is underway, and this income also needs to be taken into consideration when
estimating value. Therefore, the orderly liquidation value is generally much higher than the
distressed liquidation value [Kahl, 2002] [Petersen and Plenborg, 2012].
Liquidation plays an important part in distressed companies. A company is normally liquidated
when its assets would yield a higher value in a sale than the present value of its future earnings and
cash flow potential. It is therefore a logical and common choice when the company is in economic
distress, i.e., the company's assets are not in the highest value use. Nevertheless, as previously
mentioned, a liquidation can also be forced through litigation by the debt holders. In general, the
value obtained through a liquidation represents the lowest end of a company's value range and
normally represents the most unfavorable scenario for the equity holders [Brown et al., 1994].
However, due to the possibility of being forced into liquidation by the debt holders, it has to be
considered an important risk and must be included in the valuation.
Estimating the proceeds from a liquidation is very difficult because it ultimately depends on how
the market values the assets. This in turn is dependent on the state of the economy and the asset
specificity but also on the company's situation and the way in which the assets are liquidated. In any
case, the loss suffered by investors in the event of default is considerable. Again, both the amount at
risk, or loss given default, is dependent on the type of investment and is ultimately determined by
the particular contract or obligation.
However, while debt investments such as loans etc. have a recovery rate of between 50% to 89%,
equity investments have a much lower or, in many cases, a 0% recovery rate. Assessing the
different factors affecting the liquidation value is a research field by itself and is also out of the
scope of this study.
There are several ways to derive a possible liquidation value. One of the most common ways to
estimate the liquidation value is to use the book value of assets and to assume a discount depending
on the previously-mentioned factors. However, using the book value, which represents the amount
the company invested when it was in a better situation, tends to be over-optimistic. To correct for
this, the discount factors have to be chosen carefully.
Another option is to derive the liquidation value, similar to the DCF approach, by discounting the
cash flow generated by the assets, but with no growth prospects. Although a reasonable option, this
method should not be used in the scenario of a company in decline since these firms tend to have
negative growth rates and therefore the method would overvalue the assets. The discount on the
book value of assets is, in this case, the better option.
3.5 Other Factors in Distress
The magnitude of the effects that distress can have on the firm's operation is considerable. While a

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full analysis of the impact of distress on the firm's condition is beyond the scope of this study, there
are a few factors that are worth mentioning. Since the effects of distress vary across industries and
are, in general, influenced by the unique factors of each firm, they cannot usually be generalized
and have to be considered on a case-by-case basis. However, there are certain issues that come up
more frequently.
First of all, when making estimates regarding cash-flow projections several issues must be kept in
mind. In declining and distressed companies, working capital levels are often substantially distorted
because of liquidity problems. When analysing such a company, cash-flow impacts of such
irregularities must be taken into account, as the return to normal NWC levels can strongly affect the
cash position, which, in turn, will affect the value of the company.
It is also important to note that the tax benefits of debt can only be captured when there is enough
income to cover the interest expenses. Highly distressed firms that have negative earnings,
therefore, cannot exploit those tax benefits. This fact also has to be considered when calculating the
WACC, since tax benefits are normally included in the cost of debt [Damodaran, 2009].
Second, the cost of distress is not only quantitative but also involves qualitative factors such as
hidden costs. Among others, these include loss of reputation among stakeholders, unmotivated
employees and depressed relationships with clients. Various studies have analyzed these hidden
costs and estimated them to be in the range of 10% to 20% of the value. Therefore, the impact of
these hidden costs on the firm's value also have an impact on the risk of default and have to be
accounted for in the valuation [Almeida and Philippon, 2006] [Andrade and Kaplan, 1998].
4 The Model
The goal is to develop a model that adapts the traditional valuation tech-
niques in order to include the risks faced by distressed companies and, most
importantly, the risk of default. There are several ways to incorporate the
effects of this risk into the estimated value of the company. The most widely-
used methods for companies with distinct features include, among many
others, the modified DCF approach, the Adjusted Present Value approach,
the Simulation approach and the Relative Valuation approach. Every com-
pany has unique features that must be taken into account when making
a valuation. Depending on these features and characteristics some valua-
tion methods offer certain benefits over others. All of these methods have
shown some very distinct results, also in the case of distressed companies
[Damodaran, 2009]. This research study, however, seeks to establish a some-
what different approach that, although based on the traditional methods,

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specifically addresses the risk of default during the valuation process. This
method separates the going concern assumption from the bankruptcy situa-
tion which is represented by a distressed sale. The idea is to capture all the
risk associated with decline and distress in the probability—a forward-looking
default metric—which is then used to weigh between the going concern value
and the liquidation value. The following equation (1) summarizes the main
idea behind the model:
FirmValue = EVGoingConcern × (1 – pd) + LVDistress × pd (1)
where EV is the Enterprise Value of the firm as a going concern, pd is
the probability of distress and LV is the Liquidation Value of the firm in
a distress liquidation scenario. Separating the going concern value from the
probability of distress allows for the use of traditional methods such as the
DCF, including its assumption that the firm will exist into eternity, while at
the same time pricing in the risk of truncated cash flows due to bankruptcy
or liquidation. The model will use the DCF valuation method as an illus-
tration, but in theory it can also be used with other traditional methods. In
all cases it corrects for most of the issues identified in the previous section.
The main emphasis will be on adapting the DCF valuation but a possible
adaptation of the relative valuation will also be presented. The probability of
default will be estimated using a model introduced by Moody's KMV, which
is based on option pricing theory [Crosbie and Bohn, 2003]. In order to ex-
plain the variables and inputs in equation (1) this section will first determine
the going concern value by adjusting the normal DCF model to account for
the previously highlighted attributes of distressed firms and, second, will in-
troduce a theoretical model to estimate the probability of default during the
projection period and, third, will explain how the liquidation value is derived
for companies in distress.

4.1GoingConcernValue
The main assumption underlining the Going Concern Valuation is that the firm will survive and
return to financial health in the future. The going concern value, the value of the company with no
default prospects, can be estimated using various traditional models. This research study will focus
mainly on the DCF Valuation method. Since the risk of default is dealt with separately in this
model, it is not necessary to include this risk in the cash-flow projections or in the discount rate.

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However, in order to make reliable estimates, it is important to take the issues identified in the
previous section into account and include them in the calculations. The Enterprise Value will then
be calculated using the normal DCF method.
EV=
∑ (FVt / (1 + rc)^t) + (TerminalValue / rc)
4.1.1Cash-FlowProjection
When making cash-flow projections, it is assumed that the firm will manage to turn its operations
around, from decline and financial distress back to profitability. This is normally accomplished
through significant restructuring measures which will affect the growth prospects of the firm. To set
this path to recovery, reasonable profitability measures have to be estimated. This is done by
analyzing the firm’s historical operating margins and return on capital, and comparing them to the
industry average. There are three important metrics that have to be estimated for the cash-flow
projection, namely Revenue Growth, Operating Margins and Tax Rate. In general, it is assumed that
restructuring measures will significantly depress revenue growth in the early years but that growth
will pick up substantially thereafter until reverting back to the industry average at the mid-end of
the projection period. Financial distress usually has a significant impact on Operating Margins.
Here it is assumed that the restructuring efforts will gradually alleviate margins and continue to
improve by linear increments back to the industry average. In many cases, the high leverage of
firms in distress significantly reduces the effective tax rate. The tax rate is low in the beginning but
increases as the firm’s situation improves [Damodaran, 2009] [Bodie et al., 2011] [Brealey et al.,
2011].
Lastly, to estimate the free cash flow, the firm’s reinvestment rate over the projection period has to
be estimated. The reinvestment rate for the company is highly dependent on the situation of the firm
and its characteristics. However, due to the depressed financial situation, the firm will avoid
reinvestments if possible and seek higher utilization from its past investments. Again, this is highly
dependent on the firm’s situation and the goal of the restructuring plan. The benefits of postponing
reinvestments is that there will be certain cash inflows from depreciation charges which will
improve the cash position.

4.1.2DiscountRateCalculation
The constant change in the capital structure of the company will have a direct effect on the discount
rate. On its path back to financial health, the company's capital structure is expected to change
constantly because the reduction in leverage will result in a more favorable cost of capital.
Improvement in leverage, although dependent on the restructuring plan, is most likely to be gradual

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over time, being greater in the beginning and then smaller as the company approximates the
industry average. To include this change in the capital structure and the change in the cost of capital
the different variables have to be re-adjusted several times over the projection period [Damodaran,
2009]

The Discount Rate Calculation will be based on a normal WACC estimation. Therefore, both the
Cost of Equity and Cost of Debt have to be calculated.
The Cost of Equity is calculated by identifying the unlevered β of industry peers. It is important to
use the unlevered β in a distressed company scenario because it is more up-to-date than the
regression β, while at the same time correcting for the impact of leverage, which in many cases can
distort the results. To derive the firm’s normal β, it has to be re-levered by the firm’s Debt/Equity
Ratio. To do so, the market value of both equity and debt have to be calculated. The market value of
equity can easily be derived from the market prices. The market value of debt is more difficult to
obtain directly, since firms have a lot of non-traded debt, which is normally specified in book value
terms [Brealey et al., 2011]. One possibility is to convert this into market value debt, to treat the
entire book value of debt as one coupon bond. The coupon is set equal to the interest expenses, with
an weighted average maturity of the short and long term debt, and then the coupon bond is
calculated using the current cost of debt for the company². The following equation summarizes this
procedure.
Debt = Interest Expense × [1 – (1 / (1 + r) ^n) / r] + (Face Value Debt / (1 + r) ^n) (3)
Then, to derive the levered beta, it is multiplied by the Debt/Equity ratio and adjusted for the tax
shield provided by debt. The levered or normal company β can therefore be derived by the
following formula:
β = β_unlevered × [1 + (1 – rtax) × (D/E)] (4)
Once the β of the company has been derived, the CAPM formula can be used to calculate the Cost
of Equity [Bodie et al., 2011].
re = rf + β × (rm – rf) (5)
The Cost of Debt is derived by using the Default Spread on the company's Bond rating. The reasons
for using this method have been discussed in an earlier section. Depending on whether the firm is
able to exploit the full tax benefits from debt, the Cost of Debt should also be adapted for these
benefits. The Cost of Debt, including the tax shield of debt, is therefore calculated by the following
formula:
rd = (rf + Default Spread) × (1 – rtax) (6)
Finally, the Discount Rate used in DCF Valuation is based on the cost of capital derived by the

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WACC approach.
²Converting the debt into a single class of debt with the described characteristics will be useful
when predicting the probability of default using the Black and Scholes model later in this essay
rc = WACC = (D / (D + E)) × rd + (E / (D + E)) × re
4.1.3TerminalValueCalculation
In order to complete the valuation, after the projection period a terminal value is estimated that
reflects the value of the firm from that point onwards. Because the firm is assumed to be in a
healthy condition beyond the projection period, the Terminal Value can be calculated without major
adjustments. There are several ways to calculate the Terminal Value. While the multiple approach
or the liquidation approach could also be used in this case, the most suitable approach in this
scenario is the stable growth model. This model is explained in the following equation:
Vterminal = [NOPAT × (1 + g) (1 – Reinvestment Rate)] / (rc – g) (8)
Then, by putting the projected Cash Flows, the Cost of Capital and the Terminal Value together, we
can derive the Going Concern Value of Operating Assets using formula (2).
4.2DistressedLiquidationValue
As previously highlighted, two methods are available for estimating the Distressed Liquidation
Value of a firm. The choice between the two methods depends on the availability of information.
The most practical way to estimate the distress sale proceeds is to consider them as a percentage of
book value of assets. However, it is somewhat difficult to make a good assumption of the discount
on book value applied i.e., which percentage of book value is used. Normally, the value is derived
from the experience of other distressed liquidation within the industry. There is a significant amount
of information available regarding distressed firms, but since every industry is different and every
asset has its own characteristics, such information might not be applicable [Brown et al., 1994].
Besides, in many cases the assets of the company are very industry-specific and cannot be used for
other business areas.
Therefore, another method based on the concept of the DCF approach can be used to value the
company's assets. The main idea is that the asset's value is determined by the future cash flows they
can generate. Therefore, the average EBIT of the past years is calculated in order to reflect the
earning power of the assets and is then discounted by the cost of capital. The following formula can
be used to calculate the value of the company's assets:
Value Of Assets = [EBIT × (1 – rtax)] / Cost of Capital (9)
It has to be noted that no growth is assumed. This formula then derives the value that a healthy firm
would be willing to pay for the company's assets. While this approach is more accurate than just
using the book value of assets, it does not reflect the loss in value the company might suffer because

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of the bad bargaining position in distress and other external factors. Depending on the situation of
the firm and the economy, certain discounts should be applied. Since the amount of discount is
dependent on the characteristics of the firm, it has to be estimated on a case-by-case basis.

4.4 Relative Valuation

The previously introduced valuation model can also be used with the relative valuation approach. In
this case, the going concern valuation is performed using a market multiple method instead of the
discounted cash flow method. Again, since the model completely separates the risk of distress from
the going concern valuation, a normal multiple analysis can be performed. This means that the most
comparable firms’ multiple, including healthy ones, can be used during the analysis, thus increasing
the number of comparable firms and compensating for the previously identified problems. The
relative valuation is thus performed in the usual way, using values from operations such as
revenues, EBIT, etc. and multiplying them by the comparable firms’ multiple in order to derive the
firm’s value. Once the relative value is derived, it is used as the going concern value for the firm
and is then weighted by the probability of default with the liquidation value.
In order to further improve the accuracy of relative valuation in the distressed company scenario, a
time-series multiple can be used. This means that the relative valuation is performed using a
forward-looking multiple based on a consensus estimated future figures such as revenue, which is
then compared across industries. The idea behind this is that if a distressed firm is compared to an
industry of primarily healthy firms, then it will appear to be undervalued. To get a more accurate
picture of the company, the differences in risk, revenue growth and expected profitability need to be
analyzed over a longer period of time. However, since the risk of default is determined using a
market based method it is assumed to have forward looking characteristics already.

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