Firm Valuation with Bankruptcy Risk

Traditional firm valuation discounts forecasted cash consequences that are understood as expected values under some scenario. It is not clear how, and to what extent, uncertainty is incorporated in the valuation. This article constructs a new valuation model where uncertainty, in particular bankruptcy risk, is explicitly included. Bankruptcy denotes a failure situation where a company ceases to operate and its assets are liquidated. At the end of each year, there is a jump to one of three possible states of the world at the end of the following year. A state is a combination of sales revenue for the firm being valued and return on the market index. The third state implies bankruptcy for the firm. The new model includes both the non-steady-state explicit forecast period and the steady-state post-horizon period and derives consistent values for the unlevered firm, the debt, the tax shields, the equity, and the levered firm. All discount rates, and the promised debt interest rate, are derived from certain basic parameters, using the CAPM. The model structure, in particular the manner in which sales revenue serves as driving variable, implies that one needs to perform only one discounting operation for each year, like in Fama (Journal of Financial Economics 5:3–24, 1977). A small annual bankruptcy probability is seen to lead to a noticeable value decrease. There is also a discussion of how to combine traditional firm valuation with inputs from the new valuation model, so as to take bankruptcy risk into account.