Question

Discounted cashflow valuations are usually based upon the assumption that the firm will survive as a going concern. If you are valuing a young firm or a distressed firm where there is a significant likelihood that the firm will not make it as a going concern, how do you reflect that in your valuation?

Answer 1

In case of a going concern, we'll usually assume a company is an on going concern and project cash flows for about let's say ten years and calculate terminal value of eleventh year assuming the final valuation in the final year. Here the discount rates considered will not change. But when one discusses about a company which is in distress,by the time you reach to the level of calculating the terminal value, the company's value get's eroded. One can also make use of Monte Carlo Simulations to project at which level or year would the cash flows begin to erode and calculate the total firm's value which is facing the distress. While calculating the distressed firm, you cannot use the same way we've used the discount value and multiples as in the traditional DCF Calculations. DCF valuations for the distressed companies will carry the undermined figures. We consider the probability of the failure of companies while adjusting the discount rates and multiples. We reflect the failure as in probabilities while calculating the valuation as Estimated cash flow under each simulation multiplied by probability of each failure simulation, and that's the cash flow you can arrive at a valuation. Bond rating could be used as an example of probability simulation. Also there is another method by using Adjusted Present Value method where you'd reflect the distress by subtracting the expected bankruptcy costing debt from the unlevered company value.