Evaluation of claims on distressed firms. A conceptual framework based on structural models (PDF)

Master's Thesis from the year 2017 in the subject Business economics - Investment and Finance, grade: 12/12, Copenhagen Business School (Department of Finance), language: English, abstract: Within this thesis, we develop and apply a comprehensive, yet tractable framework comprising 10 sequential steps for the evaluation of claims on corporations suffering from distress. While traditional industry approaches yield consistent and unbiased valuations for claims on a healthy firm's assets, we find encumbering evidence that results may be distorted if the valuation object experiences severe financial or economic difficulties. Standard present value, multiple, or accrual based equity valuation methods are deterministic in nature and hence, fail to properly account for the elevated idiosyncratic uncertainties surrounding distress.

Initiated by Merton (1974), on the other hand, asset pricing research has suggested structural models as a theoretically superior alternative explicitly incorporating the optionality features and asymmetric payoff-profiles of limited liability claims. However, these models have been rarely adopted by industry professionals for their proclaimed complexity, lack of transparency and stylized assumptions on the valuation object's capital structure.

Accordingly, the proposed framework aims to overcome the above shortcomings of the original Merton (1974) model and eventually allows for an intuitive, seamless pricing of multiple claims with diverse maturity and coupon profiles based on their absolute priority ranking in bankruptcy. First, we provide a thorough characterization of both economic and financial distress and accompanying (firm) characteristics based on which a framework applicability assessment can be performed. Besides, we stress a comprehensive discussion how model input parameters can be estimated reliably.

Subsequently, we perform a holistic application of the framework to the distressed German air carrier Air Berlin. Model outputs imply a current market undervaluation of common equity by 52%. While our analysis demonstrates remarkable upsides of the framework compared to traditional valuation procedures, we conclude that a separate estimation of a going concern- and a liquidation value only partially circumvents frictions associated with the computation of a distressed firm's overall asset value. Moreover, we find that model results are highly sensitive to changes in input factors in general and the expected asset drift rate in particular, implying a considerably low robustness to estimation errors.