La Valutazione di

Aziende in Crisi

Possibili Approcci
Marco Vulpiani

“…And so castles made of sand

fall in the sea, eventually…”

(Jimi Hendrix,“Castles Made of Sand”)

1
References: M. Vulpiani, "Special Cases of Business Valuation", 1st edition, McGraw Hill (Chapter 5)
Contents
1. Definition of Distress
2. Possible approaches of valuation
3. The choice of valuation method
4. Bankruptcy Prediction Models
5. Cost of Capital for Distressed firms
6. Cases of Distressed Business Valuation
7. Contacts

2
The valuation of Distressed firms
Definition of Distress

There is no universal definition of distress, however, on the general subject of distress,

analysts often distinguish between financial distress and operational distress:

Financial Distress: • A company cannot meet, or has difficulty paying off,

its financial obligations to its creditors;
• Usually stems from high interest charges, which
affect the ability to access capital markets;
• The debt overhang pushes management to focus on
the short-term outlook and forces them to reject
profitable investment opportunities in the medium to
long term due to a lack of resources.

Operational Distress: • Is attributable to non-recurring events;

• Operational distress could also arise as a direct result
of financial distress (financial charges).

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The valuation of Distressed firms
Definition of Distress

Critical issues in
the valuation
effort
1
Greater difficulty in
Difficulties in determining future cash
facing the Financial Financial Disequilibrium
flows
Debt

2
Greater difficulty in
estimating the risk level

Profit & Losses

3
with negative Economic Disequilibrium
margin Historic performance
only representative of
profitability in situations
of normal efficiency

4
Contents
1. Definition of Distress
2. Possible approaches of valuation
3. The choice of valuation method
4. Bankruptcy Prediction Models
5. Cost of Capital for Distressed firms
6. Cases of Distressed Business Valuation
7. Contacts

5
The valuation of Distressed firms
Possible approaches of valuation
1 Distress Analysis

2 Valuation Process
Phases of valuation

Analysis of the distress should begin with the fundamental analysis of the company in
order to identify and analyze the causes of the crisis. These causes can be occasional or
structural; in the former, the economic crisis shows chances of recovery.

Loss
recoverability
The evaluation will be
carried out applying the
Financial or/and Could the Financial most appropriate
Economic Distress Distress be ridden out? methods

Fundamental
Valuation Process
analysis

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The valuation of Distressed firms
Possible approaches of valuation
1 Distress Analysis

2 Valuation Process
Phases of valuation

The next step is the selection and application of the valuation method best suited to the
situation. Internationally recognized valuation methods can be divided into the following
criteria, each of which comprises many methods:

Cost criterion Asset methods

Financial methods/
Flows criterion Income methods
Criteria

Mixed criterion Mixed methods

Stock Exchange Multiple Methods/

Market criterion Comparable Transaction Methods

7
The valuation of Distressed firms
Possible approaches of valuation

Key issues

Can multiple methods be applied Can financial methods can be

to distressed firms? applied to distressed firms?

• Multiple methods can lead to serious Theoretically, financial methods (and in

error. particular APV), thanks to their flexibility in
modelling companies results evolution,
• Application of available multiples for would seem to be most suitable for the
such companies tends to overestimate valuation of the distressed firms.
the value of the business.
Critical issues in their application:
• It is very difficult to define the
normalized level of results to apply the • Weight of Terminal Value
method.
• Recovery period estimation

• Cost of Capital estimation

8
The valuation of Distressed firms
Possible approaches of valuation

Applicable methods

Applicable methods

Financial Asset based & Option value

methods Mixed methods method

Changing Capital Adjusted Present

Structure Value method

9
The valuation of Distressed firms
Possible approaches of valuation

Adjusted Present Value Method

PV = Present Value of net cash flows;

PVKeu= Present Value of net unlevered cash flows discounted at unlevered cost of equity capital keu;
PVts = Present Value of tax shield due to interest expense on debt capital;
PVdc = Present Value of net distress-related costs.

• When a firm is in financial distress, the interest charges usually exceed the taxable
income, therefore the tax deduction will be take place in future years;
• The net distress-related costs represent the impact on the business operations and
reflect the net tax savings, resulting from carry-back and carry-forward of the operating
loss deductions(*).

(*) Pratt S.P., 2010

10
The valuation of Distressed firms
Possible approaches of valuation

Changing Capital Structure Method

The main difference with the ordinary DCF is that, given the assessment of an ever-
changing capital structure, the valuation is carried out assuming a specific WACC for
each forecast year and extending the forecast period until a stable, normalized situation
is reached.

Changing Capital Structure Method

In other words the Changing
CF1 CF2 … CFn, norm Capital Structure Method
consists in estimating the
Discounted: @ @ @ terminal value (in
DCF WACCnorm WACCnorm … WACCnorm normalized business
condition) of a company no
Changing Capital longer in distress.
WACC1 WACC2 … WACCnorm
Structure

11
The valuation of Distressed firms
Possible approaches of valuation

Changing Capital Structure Method

• A problem of circularity arises. In fact, to calculate the cost of capital components (in
particular the debt-to-equity ratio) we need to know the equity value. But to know the
value of equity we need to know the cost of capital.
• This problem of circularity can be resolved with an iterative approach to converge on
value estimates where the values we use as input are consistent with the values we get
as output.

Two approaches

Simplified Approach Detailed Approach

Calculate each year the value for that year

Calculate the debt-to-equity ratio for with an iterative approach starting
every year on the basis of some from the last year and reverting back to
simplifying assumptions. the market value of equity at the
reference date.

12
The valuation of Distressed firms
Possible approaches of valuation

Changing Capital Structure Method

Simplified Approach Detailed Approach

• Within the Simplified Approach we • Within the Detailed Approach,

can assume, in estimating WACC starting from the terminal value,
for the terminal value, that the we can determine the value in
debt-to-equity ratio, in a each year on the basis of the
normalized situation, is aligned value of the company in the
with the average market value. subsequent year and summing
up the cash flows discounted at a
cost of capital determined with the
iterative approach.

• For simplicity’s sake, in the

following example we assume that
the period for the company under
valuation to revert to a normal
situation is three years…

13
The valuation of Distressed firms
Possible approaches of valuation
Detailed Approach
Changing Capital Structure Method

1 Estimating the value of the firm at the horizon date (Year 3) when the firm is expected to
achieve a stable capital structure. We run a constant growth model.

2 To obtain the WACC for the last year of the forecast period an iterative approach is utilized.

3 We start to calculate backward the Enterprise Value for the previous year (Year 2)
through the application of a one-period valuation model.

4 WACC2 is computed by making use of the capital structure prevailing in Year 2, estimated
always with an iterative approach.

5 The backward process steps back until the present time.

Cost of capital (WACC), enterprise value (EV) and its component of debt and equity, determined
6 with the iterative approach in the last step, are the output we were looking for as at the
reference date of the valuation.
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The valuation of Distressed firms
Possible approaches of valuation
Detailed Approach
Changing Capital Structure Method

CF1 CF2 CF3 Normalized Situation The Backward process

to determine WACC at
1 2 3 4 5 … ∞ the reference date

CFnorm CF (1 + g)
EV3 = = 3
(w3 - g) (w3 - g)

EV2 =
CF3
+
EV3 Split in Equity and D/E3
(1 + w2) (1 + w2) Debt

CF2 EV2
EV1 = +
(1 + w1) (1 + w1)

CF1 EV1 EV3 WACC3

EV = +
(1 + w) (1 + w)

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The valuation of Distressed firms
Possible approaches of valuation

Asset-based and mixed methods

Asset based & Mixed

methods

Asset methods Mixed methods

Asset-based method
With autonomous
In the case of a company estimate of goodwill Average Equity-
without room for recovery, (badwill) with defined or Income value
the asset-based method indefinite period
should be adopted to
estimate the liquidation
value, net of liquidation costs. Mixed methods can be applied when the company
is going through a temporary period of distress,
followed by a period where the company reverts
to a “normal” going concern state.
16
The valuation of Distressed firms
Possible approaches of valuation

Option valuation methods

• Option pricing theory can be applied to value the equity of distressed companies(*);
• With this approach, equity in a distressed business is considered as a call option that
corresponds to the option to liquidate the firm.

Net Pay off on

Call

Strike
Price
Price of underlying
asset

(*) Damodaran A., 1997

17
The valuation of Distressed firms
Possible approaches of valuation

Option valuation methods

• The Black and Scholes model has proved to be very effective in the valuation of
many listed options.
• The model is based on the idea of creating an equivalent portfolio made up of the
underlying asset and of a risk-free investment with the same cash flows, and
therefore the same value, as the option under consideration.
• The value of a call option in the Black-Scholes model is a function of the following five
variables(*):

N = Normal Distribution
𝐂𝐚𝐥𝐥 𝐕𝐚𝐥𝐮𝐞 = 𝐒 𝐍 𝐝𝟏 − 𝐊𝐞−𝐫𝐭 𝐍 𝐝𝟐 S = Stock Price
t = Time to expiration
𝑺 𝝈𝟐 K = Exercise Price
𝒍𝒏 + 𝒓+ 𝒕
𝑲 𝟐 r = Risk-free rate of return
𝒅𝟏 = 𝒅 𝟐 = 𝒅𝟏 − 𝝈 𝒕
𝝈 𝒕 σ2 = Variance of return on stock

(*) M.Vulpiani, "Special Cases of Business Valuation", 2014, Chapter 9

18
The valuation of Distressed firms
Possible approaches of valuation

Option valuation methods

• where V = value of the firm and D =
V – D, if V > D face value of the outstanding debt
and other external claims.
Payoff
• Firm shareholders are paid on a
0, if V ≤ D residual basis after all other financial
claim-holders have been satisfied. They
Payoff of are therefore remunerated if the value
Equity of the firm is more than the value of
the outstanding debt.
• On the other hand, they cannot lose
Value of more than their investment in the firm
option if its value is less than the value of the
outstanding debt (principle of limited
liability).

Business
Enterprise Value
K
19
The valuation of Distressed firms
Possible approaches of valuation

Option valuation methods

The following five variables are considered in the Option valuation method, where
the call option corresponds to the option to liquidate the firm.

Value of the underlying asset Value of the firm

Strike price Face value of outstanding debt

Life of the option Life of zero-coupon debt

Change in the value of the

Change in firm value
underlying asset

Treasury bond rate corresponding

Risk-free rate
to option life

20
The valuation of Distressed firms
Possible approaches of valuation

Option valuation methods: Black-Scholes equation(*)

𝐑 𝐟 𝐧−𝐢
𝐅𝐌𝐕𝐞,𝟎 = 𝐅𝐌𝐕𝐁𝐄,𝟎 𝐍 𝐝𝟏 − 𝐅𝐝 𝐍(𝐝𝟐 )
FMVe,0 = Fair Market Value of Equity at time 0;
FMVBE,0 = Fair Market Value of Business Enterprise Value at time 0;
N(*) = Cumulative normal density function (the area under the normal probability distribution);

FMVBE,0 1 FMVBE,0
log + R f + σ2 n−i log + Rf n − i 1
Fd 2 Fd
𝐝𝟏 = = + σ n−i ;
σ n−i σ n−i 2
Fd = Face value of outstanding debt;

n-i = Time to maturity of debt or time to a liquidating event from period i to period n.
Rf = Risk-free rate;
σ = standard deviation of the value of the business enterprise
𝐝𝟐 = d1 − σ n − i.

(*) Pratt S. P. and Grabowski R. J., 2010

21
Contents
1. Definition of Distress
2. Possible approaches of valuation
3. The choice of valuation method
4. Bankruptcy Prediction Models
5. Cost of Capital for Distressed firms
6. Cases of Distressed Business Valuation
7. Contacts

22
 The valuation of Distressed firms
The choice of valuation method

Valuation methodology
DCF Changing APV Mixed Asset Option Multiples
Capital based Value
Structure

Very
strong
Not
recoverable
Crisis degree

Strong
recoverable

Medium

Weak

Suitable Partially suitable Poorly suitable Unsuitable

23
Contents
1. Definition of Distress
2. Possible approaches of valuation
3. The choice of valuation method
4. Bankruptcy Prediction Models
5. Cost of Capital for Distressed firms
6. Cases of Distressed Business Valuation
7. Contacts

24
The valuation of Distressed firms
Bankruptcy Prediction Models

• The last threshold of distress is bankruptcy(*);

• Analysts can use bankruptcy prediction models in order to estimate the degree of
severity of business distress.

Bankruptcy Prediction Models

Accounting-
Market-based
ratio-based
models
models

They use a company-specific debt/equity ratio

and the estimate of the company’s asset
volatility to forecast the likelihood of default on
debt (distance to default).
(*) Pratt S. P., 2010; Damodaran A., 2002
25
The valuation of Distressed firms
Bankruptcy Prediction Models

Altman Z-score

• The Altman model falls into the category "accounting-ratio-based models";

• The first formulation of the so-called Z-score model dates to 1968;
• Five of the possible 22 financial and economic ratio were chosen in consideration of
the predictive power of bankruptcy of each variable.

Publicly
𝐳 = 𝟏. 𝟐𝒙𝟏 + 𝟏. 𝟒𝒙𝟐 + 𝟑. 𝟑𝒙𝟑 + 𝟎. 𝟔𝒙𝟒 + 𝟎. 𝟗𝟗𝟗𝒙𝟓
traded firms

Private firms
𝐳′ = 𝟎. 𝟕𝟏𝟕𝐱𝟏 + 𝟎. 𝟖𝟒𝟕𝐱𝟐 + 𝟑. 𝟏𝟎𝟕𝐱𝟑 + 𝟎. 𝟒𝟐𝟎𝐱𝟔 + 𝟎. 𝟗𝟗𝟖𝐱𝟓

Non-
manufacturing 𝐳 ′′ = 𝟔. 𝟓𝟔𝒙𝟏 + 𝟑. 𝟐𝟔𝒙𝟐 + 𝟔. 𝟕𝟐𝒙𝟑 + 𝟏. 𝟎𝟓𝒙𝟔
firms

26
The valuation of Distressed firms
Bankruptcy Prediction Models

Where

z = Overall index x4 = Market value of common

equity/ Book Value of total
x1 = Net Working Capital/ total assets; liabilities;
x2 = Retained earnings/total assets; x5 = Sales/ total assets.
x6 = Book Value of common equity/
x3 = EBIT/ total assets;
Book Value of total liabilities;

Cut-off scores Cut-off scores Cut-off scores

Zones of discrimination
Publicly traded Private Non-man. firms

z > 2.99 z' > 2.90 z'' > 2.60 = safe zone

1.80 < z < 2.99 1.23 < z' < 2.90 1.1 < z'' < 2.60 = grey zone

z < 1.80 z' < 1.23 z'' < 1.1 = distress zone

27
Contents
1. Definition of Distress
2. Possible approaches of valuation
3. The choice of valuation method
4. Bankruptcy Prediction Models
5. Cost of Capital for Distressed firms
6. Cases of Distressed Business Valuation
7. Contacts

28
The valuation of Distressed firms
Cost of Capital for Distressed firms

• When the object of the valuation is a distressed firm, it will have a higher cost of capital,
in terms of both the cost of equity and the cost of debt, and thus a lower firm value
than a non-distressed company;

• Thus the risk of financial distress must be included in the calculation of the Cost of
Capital in order to capture the specific context of the observed company;

• this type of risk falls under the wide range of idiosyncratic risk;

• As a consequence, the risk of financial distress, as a company-specific risk, must be

taken into account in the calculation of the discount rate.

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The valuation of Distressed firms
Cost of Capital for Distressed firms

Cost of Equity for Distressed firms

For distressed firms, in the calculation of the cost of equity using the CAPM, the beta will
undervalue their risk if it is estimated on the basis of returns achieved in periods that are
not representative of the context of distress.

Methods of adjustments(*)

building a bottom-up estimate of beta, relevering it and adding both a size premium
from the SBBI data and a company-specific risk referred to the distress risk;

estimating the operating risk of the distressed firm and matching it with observed
market returns;

using the Fama-French three-factor model;

adjusting the CAPM cost of equity by adding a high-financial-risk premium; one of

the most important sources of premiums over CAPM is represented by the Duff &
Phelps Risk study(**);

using a risk measure based on implied volatility derived from options.

(*) Pratt S. P., 2010 (**) Duff & Phelps, 2013

30
The valuation of Distressed firms
Cost of Capital for Distressed firms

Cost of Equity for Distressed firms: an application of Altman model

• This method involves adding to the general formulation of the CAPM the premiums that
exceed the CAPM Cost of Capital, which are provided by Duff & Phelps(*).

• This can be reasonably considered as a possible formulation of the Expanded CAPM.

1 Calculating the cost of equity according to the Capital Asset Pricing Model (CAPM);

Adding to the Cost of Equity the premium determined on the basis of Duff & Phelps
2
report(*).

Manufacturing Size Premium

Premium over CAPM for Range Zone of discrimination Premium Over CAPM
manufacturing firms 1.81 < Z < 2.99 Grey 7.32%
Z < 1.81 Distress 9.14%

Services Size Premium

Premium over CAPM for
Range Zone of discrimination Premium Over CAPM
non manufacturing and
1.1 < Z < 2.59 Grey 13.12%
services firms
Z < 1.1 Distress 20.03%

(*) Duff & Phelps Risk Premium Report, 2013

31
The valuation of Distressed firms
Cost of Capital for Distressed firms

Cost of Debt for Distressed firms

When calculating the Cost of Debt of Distressed firms two key issues arise:

the higher the financial leverage of the company, the higher the cost of debt on
account of the greater exposure to the risk of default;

we must also consider the non-deductibility of interest expense and, thus the
reduction of the tax benefits relating to operating losses.

APV formulation of Business Enterprise (BE) value

Value of Levered BE = Value of the Unlevered assets + PV of Tax Shield

32
Contents
1. Definition of Distress
2. Possible approaches of valuation
3. The choice of valuation method
4. Bankruptcy Prediction Models
5. Cost of Capital for Distressed firms
6. Cases of Distressed Business Valuation
7. Contacts

33
The valuation of Distressed firms
Cases of Distressed Business Valuation

Different approaches according to the

financial structure considered can be used

1 2 3
Prospective financial Punctual financial Punctual financial
structure structure structure

Changing Capital
Adjusted Cash Flow APV
Structure

34
The valuation of Distressed firms
Cases of Distressed Business Valuation
1
Prospective financial
structure

• The table below shows the equity value of the company considered estimated using the
DCF Unlevered method, assuming in the WACC calculation, a prospective financial
structure and referring to the adjusted cash flows to take into account the risk of
insolvency (“FCF –RofInsolvency %”).

UDCF 2018 2019 2020

TV
(EUR) Forecast Forecast Forecast
Flusso di cassa operativo (50) (10) 55 85
Rischio di Insolvenza (%) -10% -10% 10% 10%
FCF - RdInsolvenza % (55) (11) 50 77

Period 0,5 1,5 2,5 2,5

Discount Factor 0,948 0,851 0,764 0,764

Discounted FCF (52) (9) 38

WACC 11,4%
g 1%
Capitalization Factor 9,80

Sum of FCF (24)

PV of TV 580
VA costi di dissesto (100)
Enterprise Value 455,86

PFN 700
Equity Value (244,14)

35
The valuation of Distressed firms
Cases of Distressed Business Valuation
2
APV

• Applying the APV, first of all the Unlevered Enterprise Value is estimated, i. e. the value
1
of the enterprise in the event of no debt.

•2 The second step consists into estimate the present value of the tax benefits from
financial charges.

•3 Third part consists in the valuation of the present value of the cost of failure.

APV
Unlevered Enterprise Value 527,6
Benefici fiscali del debito 37,0
VA costi di dissesto (110,0)
EV 454,7

PFN 700
Equity Value (245,3)

36
The valuation of Distressed firms
Cases of Distressed Business Valuation
3
Changing Capital
Structure

• The Changing Capital Structure Method considers the effective financial structure of the
recovery plan and the WACC as a discount rate on operating cash flows.

• The application of this method takes into account the evolution of the debt over the
analysis period and a WACC that may reflect the risk of default for each forecasted year
given this evolution.

• In this case, it is necessary to extend the explicit forecast period until a normalized
financial structure is achieved.

2018 2019 2020 TV

Flussi di cassa (50,0) (10,0) 55,0 85,0
D 700,0 700,0 600,0 350,0
E (140,4) (15,3) 179,7 470,9
D/E 0,00 0,00 3,34 0,74
WACC di periodo 13,4% 12,4% 12,3% 11,4%

EV TV 820,9
EV 2020 779,7
EV 2019 684,7
EV 2018 559,6

VA costi di dissesto (100,0)

Enterprise Value 459,6

PFN 700,0
Equity Value (240,4)

37
Contents
1. Definition of Distress
2. Possible approaches of valuation
3. The choice of valuation method
4. Bankruptcy Prediction Models
5. Cost of Capital for Distressed firms
6. Cases of Distressed Business Valuation
7. Contacts

38
Contacts

Marco Vulpiani Deloitte Financial

Equity Partner Advisory S.r.l.
Head of Valuation and Business Via della Camilluccia,
Modelling Services 589/A
00135 Roma – Italia
Direct: +39 06 36749315 P. Iva IT 03644260964
Mobile: +39 348 8856689
[email protected] Tel: +39 06 367491
www.deloitte.it

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