Valuation of Distress Company

Andrei Ignatov
2006
 Distressed company valuation

1. Intro
What is the main reason for any science? Any science, financial or natural, fundamental or
applied, finally, has one significant aim: to make our lives better. Sometimes we do not
understand its ways, it is not clear, implicit for us, but that is the point of destination. That is how
we feel the meaning of science.
What is valuation? From the first days on this planet humanity evaluates. Ancient people
thought about: how many fruits and vegetables they should take in exchange for a meat and not
take too few. With currency system development, everything has been evaluated in money. But
the same problem stayed: how to find fair value and not to make yourself a fool. Thousand years
passed, many concepts, “price” theories were devised, but there is still no unique approach. And
probably as physics goes more and more deeply into substance, failing to find ultimate particle,
economists face or do the same.
However, show must go on. This article is about company valuation. It is an interesting and
sophisticated work. That is a way you can fully reveal your analytical and creative abilities. That
one of the reason, we want to write about it.
First of all, in this article we will pay attention for distressed company valuation as special
case, which required its own approach. Of course, usual valuation techniques can be used for
distressed companies, but as some articles show 1 , these results are very unstable, and, for
example, the ratio between market and estimated values can be from 20% till 300%. Such
difference is too big and can not be accepted. That is the problem we want to solve. We want to
find out why traditional methods do not work properly and then we would like to present our
vision, our approach for distressed company valuation.

Estimated value
#2

Estimated
Market
Value ?
value #1

1
Stuart C. Gibson, Edith S. Hotchkiss, Richard S. Ruback (2000) “Valuation of Bankrupt Firms”

2
 {A few words about results: theoretical and empirical}

2. Theory and Literature review

In this section we would like to present a literature review from different financial areas,
which will play a big role of in our article. They are: the probability of bankruptcy prediction,
distress valuation, remark on traditional valuation and bankrupt firms. A “literature map” will be
presented also.
Probability of bankruptcy
Estimating this figure has a long history. In general we can stress out two main groups:
empirical and theoretical articles. And if there are many works from first group, there are few
works from the last one. So there is a lack of models, which are looking for variables, capable to
explain the difference between healthy and distresses companies. It is a big trouble for science
based bankruptcy prediction. Without clear bankruptcy essence understanding, it is hard this
problem just by looking at data in different economic conditions and time.
- Empirical approach to a probability of bankruptcy estimation. Here we can point out two
classes of models: qualitative and quantitative models. Qualitative models often used when there
is no open information about borrower. Analytic has to gain it from different sources; then he has
to make a decision about probability of bankruptcy and expediency of giving a credit or buying
debt instruments of that company. Quantitative models use data from open/observed information
of a borrower and they are able to estimate a probability of default and classify it for different
groups of credit risk. Those models give an ability to find out, which factors are important for
default risk, to compare their relative meanings, to improve monitoring systems and so on.
Quantitative models of default risk. Despite or maybe as a reason of unique corporate
bankruptcy theory absence, many empirical methods of bankruptcy prediction were developed.
In 30-s of the last century, first steps in this direction were made by Fitzpatrick 2 . He computed
various financial coefficients of normal and bankrupt companies and then compared them. As
there were no advanced statistical methods or computers, it was impossible to build any models
or other, only to fix observations. But it opened a way for further research. Also he we can
mention works of Ramster, Foster (1931) 3 , Winakor, Smith (1935) 4 , Mervin (1979) 5 . We can
highlight two ways of economic science evolution in this area. First is based on empirical
searching for a financial figure, which would have the best prediction power. Second is looking
for a statistical method, which allows making exact, accurate forecasting. In scientific research
2
P. Fitzpatrick (1930) “A comparison of the ration of successful industrial enterprises with those of failed
companies”
3
J. Ramster, L. Foster (1931) “A Demonstration of Ration Analysis”
4
A. Winakor, Smith (1935) “Changes in the Financial Structure of Unsuccessful Industrial Corporations”
5
C. Mervin (1979) “Financing Small Corporations: in Five Manufacturing Industries”

3
till 1980-s first approach was prior. During that period a discriminat analysis was the main. In
1966 it was first used by Biver as unvaried discriminant analysis. Later Altman expanded it for
MDA - Multivariate Discriminant Analysis. And it was very popular as a analysis’ tool for a
long time: Deakin (1972) 6 , Edminster (1972) 7 , Blum (1974) 8 , Altman, Haldeman and Narayanan
(1977) 9 , El Hennawy, Morris (1983) 10 . Back, Laitinen, Sere, van Wezel (1996) 11 generalize
most known results by building a summary table of financial coefficients with high prediction
power. Nevertheless, MDA had some shortcomings, and in 80-s the mainstream was searching
for a new statistical techniques (now probit and logit models). Later in 90-s an artificial neural
networks analysis became widespread. It allows us to get more precise results.
Qualitative models of default risk. In these models various factors, which may influence
company’s default, are analyzed and final judgment about company’s reliability is made. Often it
may be very subjective judgments. There are two main groups of factors: borrower-specific and
market-specific factors. The first group includes the following factors: borrower’s character or
reputation; capital leverage, income’s volatility and collateral. The second group includes:
business cycle stage (general economic situation surely influence company’s ability to pay for its
debts; that is why this feature is essential for bankruptcy prediction) and interest rate level. For
example, common increase of interest rates may lead to the increase of default probability. From
financial institution’s point of view, high interest rate means more expensive resources for banks,
which have to attract money for higher rates. That is why there are many attempts to create
artificial intelligence systems (expert systems) recently. It is a common point of view that such
well managed system based on qualitative models estimate default risk precisely. In spite of their
high efficiency in decision making those systems have some shortcomings. First, they are very
costly either in development or in maintaining. Second, it takes time greatly to translate expert’s
algorithms into the system. Third, those systems are not able to self training and modifying from
experience. All these disadvantages force to look for other approaches.
One of these qualitative approaches is based on bond rating. Different rating agencies rate
company’s bond. And there is a table, which shows probability of default for each group or
rating. All these figures are calculated based on historical facts. Of course, it is very easy way to
estimate probability of default just by looking into the table; that is why it is not good in practice.
It is too generalized, company’s specific is not used, and then different agencies may rate bonds

6
E. Deakin (1972) “A Discriminant Analysis of Predictors of Business Failure”
7
R. Edminster (1972) “An Empirical Test of Financial Ratio Analysis for Small Business Failure Prediction”
8
M. Blum (1974) “Failing Company Discriminant Analysis”
9
E. Altman, R. Haldeman and P. Narayanan (1977) “Zeta Analysis: A New Model to Identify Bankruptcy Risk of
Corporations”
10
R. El Hennawy, R. Morris (1983) “The Significance of Base Year in Developing Failure Prediction Models”
11
Barboro Back, Teija Laitinen, Kaisa Sere, Michiel van Wezel (1996) “Choosing Bankruptcy Predictors Using
Discriminant Analysis, Logit Analysis, Genetic Algorithms. Turku Centre for Computer Science”

4
its own way. So it is only can be used as express, preliminary method, like others qualitative
means.

Artificial neural networks analysis (ANNA) is a quite new method of default probability
estimation. It has a same feature as nonlinear discriminant analysis, so we can easy reject a
problem of factors independency and linear correlation between factors and default probability.
ANNA allows to analyze implicit, potential relationships between various variables, which are
included in nonlinear model of bankruptcy prediction as exploratory ones. One of the most
important features of neural networks is their ability for self-studying. It is done by comparing
model’s outputs with new facts. Number of errors is calculated, and then the weight correction is
running to reduce this number for minimum. So here are positive sides of using ANNA for
bankruptcy prediction: it is possible to find “secret” nonlinear relationships between variables;
this system is stable for external fluctuations, if some elements are not working it not destroys
the whole system; this net can generalize, it is possible to get new right conclusions even with
missing or noisy data; finally neural networks are adapting fast to new conditions by self-
studying. But of course, there are some shortcomings. ANNA could not explain the nature of
those implicit relationships, i.e. it is not easy to interpret weights from the model. It is usually
impossible to explain its logic, and sometimes it can even go to contradiction with existing
theories and common sense. More, if architecture of neural networks is more sophisticated, it is
more probable, that not logical behavior appears. So there is a big problem with checking model
results 12 .

But as experience shows well fixed and trained network can give very good results 13 . In
1993 Altman with two Italian researchers made a comparing between results, based on ANNA
and result, based on traditional methods (like MDA, logit analysis). The main conclusion is that
in most cases neural networks gave more precise results 14 . That is why using neural networks
can be very useful in addition to other methods. The only problem we can meet here, that we
need a big sample for “bad” companies to train our network well.

Theoretical models of bankruptcy prediction. The gambler’s ruin model. An example of

theoretical approach explaining default was developed by Wilcox (1971). It is a theoretical
model, based on cash flow data and capital structure of given company. Company deals as a
player and becomes a bankrupt, when all its value is sub zero. It is assumed that all cash flows

12
Hawley, Delvin D.; Johnson, John D.; Raina Dijjotam (1990) “Artificial Neural Systems: A New Tool for
Financial Decision-Making”
13
Medsker, Larry; Turban, Efraim; Trippi, Robert “Neural Networks Fundamentals for Financial Analysts”
14
Altman, Edward I.; Marco, Giancarlo; Varetto, Franco “Corporate distress diagnosis: Comparisons using
discriminant analysis and neural networks (the Italian experience)”

5
created independently, board of directors or manager’s interruption is neglected. The main
conclusion from this work, that average mean and standard deviation of net income – is the most
important indicators of bankruptcy prediction. Wilcox built his model by creating cash flows as
Markov’s processes, which can either positive or negative and book value of equity viewed as
reserve. Then a probability of default is calculated based on Markov’s cash flow movements.
Another approach is based on viewing various models of capital structure. Many statistical
theories use default as a condition to find an optimal capital structure, optimal combination of
debt and equity. Bankruptcy appears when company’s uncertain cash flows are not enough to
cover its liabilities in debt. For instance, Hol, Westgaard and van der Wijst (2003) 15 rewrite
default conditions, its features, also how optimal capital structure, cash flows (mean and standard
deviation) influence this probability. The work is based on neoclassic theory of capital structure
and it is created as a contra to option based theory. As information like capital structure and cash
flow is easy to get, this approach looks better.
As the main problem in applying option approach, using equity and assets volatility, and it
requires listing and trading for a period. However, only 1% of all firms satisfied these conditions.
It is not rational to base whole analysis for all companies, based on this 1%.
Last and the most known approach of bankruptcy prediction is option method (Black,
Sholes, Merton). Scott (1981) was one of first who tried to use it to find variables responsible for
default. Option pricing approach was extended by Delianedis and Geske (1998) 16 . And
theoretical analysis of using options for bankruptcy prediction presented by Farmen et al (2003)
17
.
Also we can mention new works, which develop real option approach today. For instance,
Lander, Shenoy (1999) 18 offer to use influence diagrams for real option modeling and
estimation. Three methods are compared: decision tree, binominal tree and influence diagram.
Authors sure, that these diagrams present the process of decision making in more appropriate and
compact way, than decision and binominal trees of option estimation. Under some assumptions
influence diagrams give the same result and same optimal strategies as usual real option
approach. Also we can mention Trigeorgis и Taudes, Natter, Trcka (1996) 19 , who used neural
networks for real option estimation.

15
Hol S., Westgaard S. and N. van der Wijst (2003) “Capital Structure, Business Risk and Default Probability”
16
Delianedis G. and R. Geske (2003) “Credit Risk and Risk Neutral Default Probabilities - Information about rating
migrations and defaults”
17
Farmen T., Fleten S.E., Westgaard S. and N. van der Wijst (2003) “Default Greeks under an Objective Probability
Measure”
18
Diane M. Lander, Prakash P. Shenoy ( 1999) “Modeling and Valuing Real Options Using Influence Diagrams”
19
Taudes, Natter, Trcka (1996) “Real Option Valuation with Neural Networks”

6
 Distress valuation
There are a lot of articles dealing with company valuation in financial science. And there are
many works about companies, which are in distress situation or in bankruptcy. But still there are
only few researches precisely about valuating distressed companies.
First, many authors like to write additional chapters about distress valuation in their texts.
For example, we can mention few books containing chapters with main methods of distressed
company valuation: Damodaran 20 , Scarberry 21 . These texts tell us about companies under
reorganization. It means they should be viewed as a special case. And authors give their own
methods for it. But a general way of dealing with such companies is by traditional techniques
modification: usually modified discounted cash flow approach.
Second there are a few works more or less entirely about distressed company’s valuation. A.
Damodaran 22 . It is a short text about main modifications in valuation for “bad” companies. This
work is a compilation of few chapters of “Investment valuation”. Anyway it gives a clear view
on many traditional and adjusted methods for distressed companies. Everything is well organized
and can be used as start point. This text consider three main techniques: discounted cash flows
(including APV), relative valuation and real option approach. The author modifies them and
gives you real tools for practice. The only gap, thing, which it is not clear enough, who is an
author, a creator of all those corrections, because Damodaran does not give any links. Also here
we can find an idea of looking at cash flows as expected cash flow with probability of distress.
Another author, Gilson 23 shows the great difference between estimated and market values. It
is an empirical work. It takes about 60 American companies, which are going to be bankrupt and
valuate them by different methods. As a result we see that endogenous estimates are not
efficient. The variation is too big with market value as a mean. They have fivefold deviation
from the mean in each direction. Such state of things is not due to model’s assumption. By
running sensitive analysis authors proved this statement. Also they think that it can be explained
only by lack of company’s information and by other institutional factors.
Almeida 24 work is a theoretical article, develops new ways of discount rate estimation for
distressed companies. An idea that distress influences greatly discount rate by additional distress
costs appearing is testing. Those distress costs influence whole company’s structure and lead to
adjustments in firm valuation. Such modifications described and may be implemented in other
models.

20
Aswath Damodaran (2000) “Investment valuation”
21
M. Scarberry, K. Klee, G. Newton and S. Nickles (1996) “Business reorganization: Cases and Materials”
22
Aswath Damodaran (2006) “Dealing with Distress in Valuation”
23
Stuart C. Gibson, Edith S. Hotchkiss, Richard S. Ruback (2000) “Valuation of Bankrupt Firms”
24
Heitor Almeida Thomas Philippon (2006) “The Risk-Adjusted Cost of Financial Distress”

7
 Remark on Traditional Valuation
When running ordinary valuation we refer to traditional works, for example, we can name
Benninga 25 , Copeland 26 and H&L 27 approaches while calculating free cash flow. All such
techniques are well developed and can be used easily.

Bankrupt firms
On the other hand, there are plenty of texts about trouble companies. They view different
aspects of such companies, like implicit and explicit costs of bankruptcy, institutional factors for
distressed companies, special assets valuation etc. These things can be useful for us, because
while valuating “bad” company, we have to take into account all those factors about potential
bankruptcy.
Bankruptcy costs: direct and indirect. Weiss (1990) 28 analyzed direct costs of bankruptcy.
As a conclusion authors find out, that direct costs of bankruptcy are estimating around 3,1% of
book value of debt and market value of equity (for a year previous to bankruptcy). It also
mentions, that company’s size plays a big role here and how can we valuate those costs,
depending on size.
29
Second article is by Wruck (1991) . From this article about bankruptcy costs, we see, that
indirect costs play more important role for distressed companies, they influence not only a
capital structure, but also an organizational structure of a company. These costs, for example, are
costs of changing company’s policy or board of director’s transformation. Indirect costs are
estimated about 9-15% of market value. Of course, this work shows, how essential that can be
and how we have to implement indirect costs in our practice.
Brown (1993) 30 . This article shows how creditors use different sales procedures in their own
interest, when company is in trouble. If it a case and cash from sales is for creditors, it is more
likely that there won’t be any change in management team of the company and stock price will
be less sensitive, than when a company itself make decision, how to deal with assets selling. This
article also shows how we can estimate possible cash flow of selling as a percent of non-current

25
Benninga, Sarig “Corporate Finance: A Valuation Approach”
26
Copeland, Koller Murrin “Valuation--Managing the Value of Companies”
27
Hackel, Livnat “Cash Flow and Security Analysis”
28
Lawrence A. Weiss (1990) “Direct costs and violation of priority of claims”
29
Karen Hopper Wruck (1991) “Financial distress, reorganization, and organizational efficiency”
30
David T. Brown, Christopher M. James, Robert M.. Mooradian (1993) “Asset sales by financially distressed
firms”

8
assets. This percent varies from 10% to 30% of book value of non-current assets, depending on
industry and some institutional factors.

Literature map
To make it easier the following picture represents a literature map, corresponding to our
topic.

Bankrupt company
Valuation

Few works: Useful works:

Traditional 1) Gilson, Weiss, Wruck,
valuation: Benninga, 2) Damodaran, Brown,
Copeland and H&L 3) Scarberry
4) Almeida
P (Default)

Probability of bankruptcy – key

works: Altman, Hawley, Delvin,
Wilcox, Hol, van der Wijst,
Farmen et al, Liao and Chen

3. Valuation theory
In general there are three main types of models in valuation of financial assets. First, income
methods (or absolute value models), when value is determined as the present value of future
expected cash flows, expected earnings from owning an asset. Second, relative methods, when
value is determined by comparing company with similar companies or deals. Finally, real option
method is modern approach for different assets valuation by option pricing models (like Black-
Scholes or binomial pricing models). Of course, each method will give its own estimations. And
it is not a problem or mistake of a method; it is a question of its nature, of its assumptions. It
means that in some cases one method can be more reliable than other. For instance, if you are
going to sell a part or a whole company, you may pay more attention to relative methods and
examine same deals with similar companies. Another limitation is that each technique based on
different financial statement. So it may happened, that it is almost impossible to use a method,
9
just because you do not have data for it. But in general, when it is possible, you should use as
many valid methods as possible. It is a common thing to argue about value as an interval, not a
point.
It is important to understand that there are many types of value: market, fair, intrinsic,
fundamental, etc. Sometimes these names are mixed, and it is not clear what is what. For our
purposes we will point out two types of value: market and intrinsic. Market value is a value,
which is made up in the market as equilibrium between supply and demand sides. Intrinsic value
is a value, which analysts determine in their analysis. It is not necessary for intrinsic value to be
equal with market value. For example, if analyst sure, that intrinsic value is less than market,
than this asset or a company is overestimated and it is better to sell it. Also it very essential to
realize that there is no unique intrinsic value, each researcher may have its own, depending on
assumptions he put in his model. If you are interested in other types of value, we refer you to:
http://en.wikipedia.org/wiki/Valuation_(finance)#Asset_valuation
www.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch1.pdf.
Another crucial thing to be mentioned is an aim of valuation. For example, buying or selling
securities (for investors), mergers and acquisition or strategic value management (for a company
itself), taxable events. Depending on a purpose, valuation may be different and some methods
become prior to others. In this work we are going to speak about valuation for investors. It is the
most common way, and usually there is no need in any additional assumptions.
Before going deep into valuation techniques for distressed company we have to define
“distressed”. As you will see, a definition search for a key terminus may give you absolutely
another vision on the whole problem you are solving.

4. Distress definition
What is meant by distressed company? In general it means that in near future company
won’t be able to fulfill its obligations. If it is a case company may go bankruptcy or be
reorganized. Then we have to valuate a company as an asset, estimate its liquidation price and so
on.
First question arises, if company is not a bankrupt yet, how can we be sure that it will be a
bankrupt. And if so, how can we find its value. As we are interested in company’s value before
something wrong will happened, it is better to speak about future bankruptcy as a probability. A
probability of bankruptcy is a key figure here. It allows us not to worry about will or will be not
company a bankrupt. Because in that case we can say it will be bankruptcy with some
probability.

10
 If we look at this from more general position, we can say that any company may be a
bankrupt. And this is true. Just for one company this probability of bankruptcy is very small, and
for another is quite big enough. Such approach solves the problem of distress definition for any
company, because any company now can be called distressed, but with different probability of
bankruptcy. It also may explain partly why traditional methods are not good with valuating such
companies. They do not catch its dialectic nature. It means that they are “fine” and “bad”
companies at the same time. And each state simple has its probability. Our approach deals with
that states of nature. Also it has very simple mathematical appearance:

FV = E{FV} = Pbankruptcy * FVbankruptcy + (1 – Pbankruptcy) * FVgoing concern

We view firm value as mathematical expectation and there are two states of nature:
bankruptcy and going concern. It obvious that if company performs well its probability of
bankruptcy is small and final firm value will be close to firm value as going concern. So the
difference between our approach and traditional one is not big enough for “fine” companies. But
as probability of bankruptcy increases firm value of “bad” company plays bigger role and
influence final firm value greater. If a company is a bankrupt, so the probability of bankruptcy is
100%, then final firm value will be equal to firm value of bankrupted company.
Now we will say a few words about each element. How can we estimate it? First, let’s view
firm value of “fine” company or going concern. Traditional methods like discounted cash flow or
relative valuation may work quite well. Of course, these methods itself have some limitations,
but there are many articles and books about how to modify them in different cases. A little
practice and you will be able to calculate firm or equity values without problems.
Second, it is firm value of bankrupt company. It is much more difficult than previous one.
Again modified traditional techniques can be used. For example, for discounted cash flow we
have to modify interest rate or for relative valuation we should look at similar “bad” companies.
But usually that is not good. Results are not very reliable. Another way is to use adjusted present
value. It looks like discounted cash flow, but has different assumptions and context. Also for
bankrupt company we can use liquidation value. This method tries to estimate sales prices for all
assets, so we can find firm value. But sometimes it is not clear will company be liquidated or
reorganized. So it is always a question of a specific case. Finally, we can use real option
approach to estimate value of equity (and firm value as following) for bankrupt company. It is
very powerful modern approach, but again there are always many questions about inputs for this
model. As an advice, it is better to use all available and reliable information, valuate firm value
by different methods and than choose one or an average between few, depending on your case.

11
 Third, it is a probability of bankruptcy. That is the most crucial and important figure in given
formula. It is a big problem to estimate it correctly. There are methods how to find it and the next
section in this work will be about its calculation. We will develop a stochastic model for
bankruptcy prediction. But what is important to understand, that it is ***

5. Empirical part
Now we would like to make it clear what are we want and what we are going to do. First, we
want to compare our approach with traditional one, to find out which one is better. By theory we
think our model is better, as more general one, catching company’s dialectic nature. But we have
to check it. As an arbiter we take a market value, so we assume market efficiency. Of course, if
market is wrong, it is not obvious what is better. So we do not know which value is closer to
intrinsic one. But anyway on these first steps we need an orienteer. Later we will try to check our
model by other means like credit ratings.
In order to make comparison,
1) we need to find a firm value by traditional method
2) a firm value by our approach should be calculated
3) compare them with market value (as orienteer)
4) make a conclusion
Now let’s look at each stage more precisely.
Traditional approach. Firm value will be calculated as sum of future discounted cash flows
(absolute approach: DCF method). Standard formulas (see Coopland31 ) for free cash flow will be
used. We are going to estimate firm value as going concern. For our telecommunication industry
we will use 2-stage model with forecast period of approximately 5 years (for some companies it
may differ), there are many argues about which length is better, we assume that 5 year is
reasonable forecast period for given industry:
General formula for firm value:
FV = pCF1+pCF2+pCF3+pCF4+pCF5+pTCF
Where pCFi is a present value of Cash Flow. TCF – terminal cash flow.
Terminal cash flow can be found from:
TCF = CF5 * (1+g) / (WACC - g)
Where g – is a constant growth rate, average industrial rate will be used here.
Weighted adjusted cost of capital is used as discount factor, because we are looking for the
whole company. The following statement for WACC:
WACC = (D/(D+E))*Kd*(1-t) + (E/(D+E))*Ke

31
Copeland, Koller Murrin “Valuation--Managing the Value of Companies”

12
Where D is debt, E is Equity, Kd and Ke – returns on debt and equity, t – taxes.
The last expression, which is not cleared yet: free cash flow. We use standard formula for
free cash flow to firm (owners and creditors):
FCFF = EBIT*(1-tax) + Deprec. - Cap.Expenditures - Investm. in Net Working Capital +
Proceeds from sale of assets
Most data will be taken from balance sheet and income statement. Also few general industry
figures will be used. As a database we are going to use COMPUSTAT. It is important to
remember, that even here it is not a simple taking from source and putting into the model. Each
figure has to be taken carefully and well founded. It means each company has to be viewed
separately, not in a group.

New approach. For our model we need three main blocks: firm value as going concern,
firm value of a bankrupt and the probability of bankrupt. Firm value as going concern can be
valuated by traditional approach, or as another possibility, we would like to develop a stochastic
model for cash flow to make more precise forecasting.
Second, while estimating firm value for bankrupt company, which is already a bankrupt
under our approach, it is better to use liquidation value. It is an amount, which you can get by
selling your company assets quickly. Based on articles *** we present the following way to find
liquidation value:
Step 1. Divide cash and non-cash assets.
Step 2. Taking into account bankruptcy costs (direct and indirect), also using world practice,
we assume that only 20% of non-cash assets can be sold quickly.
Step 3. Cash assets + 0,2*non-cash assets = firm value of bankrupt company.
Again here 20% is a rude estimation, a general view. In our work we will deal each company
separately, examining its balance, building this percent based on a specific structure of a firm’s
non-cash assets.
Finally we need the probability of default. Here we will use one of the most modern and
upcoming approach based on option pricing – real option approach. Real option approach for
bankruptcy prediction is based on option pricing techniques for financial options. There are
many theoretical works about how to valuate real options. One of the most known and used
approach was presented by Black, Scholes (1973) 32 and Merton (1974) 33 . Mathematical

32
F. Black, M. Scholes “The pricing of options and corporate liabilities”
33
Merton, C. Robert “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates”

13
formulas given in these articles can be used to estimate real option value and probability of
bankruptcy 34 .
Standard option model is based on formula Black-Scholes. It is assumed that firm value in
any period t, Vt is ruled by stationary process.
dVt/Vt = (α - Х) dt + σ dz
Where α – expected return on assets
X – company’s debt (including interest and coupons payments) as a percent of firm value
σ – standard deviation of assets returns (change of firm value in percent)
dz – standard Vinery’s process.
Basic B-S formula:
VE = VA · N(d1) – e-rT· X · N(d2) (1)
VA - market value of assets;
VE – option price;
X – nominal debt;
r – riskfree rate;
Т - time till expiration;
σ – standard deviation in assets returns, as an infinitely charging percent;
N – cumulative normal distribution function with mean 0 and standard deviation 1.

d1 =
ln(V A / X ) + (r + 0,5σ 2 )T
=
[ ]
ln(V A / X * e − rT ) + 0,5σ 2 )T
Tσ Tσ

d 2 = d1 − σ T
Last part in formula (1) – is a discounted expected firm value if it is solvent. N(d2) – is a
risk-neutral probability that company will be solvent while paying its payables. Another word,
N(d2) is a probability that VA > X. In that case company will pay principal debt X with current
value e-rT· X. Risk-neutral probability of default will be:

Prob.Default = Prob(VAT < X) = 1 - N(d2) = N( -d2) (2)

But principal debt means also paying interests and standard approach does not take into
account. If a principal debt includes interest payments to creditors we have to modify our
formulas. If we make an analogy with stocks, a case when interests are paid looks like stocks
with paying dividends. So an owner of such option do not receive these dividends, the same as
the owner, who do not buy his debt (realize his option), did not save interest payments. It means
that in that case we should use modified B-S formula for options with dividends. It looks like:
VE = VA · e-DT· N(d1*) – e-rT· X · N(d2*) (3)

34
Scholes and Merton got Noble price for creating this model in 1997

14
 d *2 =
[ ]
ln(V / X ) + (r − D) − 1 / σ 2 T
Where σ T and d *1 = d *2 +σ T

This standard option model has interesting senses in bankruptcy prediction. As can we see a
probability of default depends on five variables. So given risk-neutral default probability,
probability is higher when:
- Current firm value lower;
- Nominal debt vale higher or firm to debt ratio is lower;
- Volatility of returns higher;
- T lower, it means that soon company has to pay;
- The difference between risk free and debt interest rates is lower
All these conclusions look very real. So implementing “dividends” in the model makes it
more useful. Of course, other modifications are possible, for example, if we assume that it is
possible to go bankrupt before a point when company returns principal debt, for example, when
it pays interests. Here we should look at American type of options (expiration is possible in any
35
period before expiration date). Those modifications can be found in Charitou(2000) and
36 37
Cortazar , Carr .
That is why we can say there are many B-S model modifications were done in order to
improve explanatory power of possible bankruptcy.
Anyway there are some limitations while using B-S approach. First, this model was
developed for European options; it means they can be used till expiration date. Then constant
risk-free rate and constant volatility of assets return on the whole period is assumed. Expected
cash flows are discounted by risk-free rate, however, costs and sales uncertainty may differ from
today’s estimation. Only one spring of uncertainty is assumed. Volatility’s estimation is
conditional and may serious influence option price.

Making a comparison. After running all, what was described before, we will get three
cross-section rows of data: market, traditional and new firm values for all firms. Our task here is
to check which of the last two is closer to the market one. A simple view may not give an answer
so we will some statistical tools for that. Exactly, root mean squared error (RMSE) will be used
as a judge. MSE is equal to estimator variation plus the squared bias (between estimated and
original values). RMSE is a square root of MSE. An approach with lower RMSE will be claimed
more closed to market value.

35
Andreas Charitou, Lenos Trigeorgis (2000) “Option-based bankruptcy prediction”
36
Gonzalo Cortazar “Simulation and Numerical Methods in Real Option Valuation”
37
Peter Carr “The Valuation of American Exchange Options with Application to Real Option”

15
 6. Data
We will take American and European companies from telecommunication industry. It will
be about 20 companies from given industry and we will take those companies, which exist more
than 10 years. For calculating historical figures a period of 10-15 years will be used. Data
source: COPMUSTAT. Also data from credit agencies, like Moody’s and S&P (from official
sites) will be included.

7. Conclusion
As you can see for the current moment it is just a framework, an initial thinking. It gives you
a basic view on what is going to be done. We will estimate firm values using traditional methods
and our own ones. Then we will compare them with market value. Still many points may not be
clear yet, for instance, we do not describe a mechanism of comparing using credit ratings, and a
potential stochastic model for cash flows.
For our next step we will begin data collecting, model building and the following research.
To be continued…

16
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Option”

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