DCF-Valuations of Companies in Crisis: Distress-Related Leverage, Identification of Risk Positions, Discounting Techniques, and “Beta Flips”

From the viewpoint of a well-diversified investor, an equity investment in an operationally distressed company resembles an equity investment in a financially levered company. However, the risk characteristics of the “virtual debt” in a distressed company are not necessarily identical to those of typical financial debt, which makes investments into distressed companies unique. In this paper, we show that risk-adjusted discount rates of distressed companies can differ quite significantly from those of healthy companies. We further illustrate how to determine such discount rates and how to account for these findings in practical discounted cash flow valuation cases.