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.
Table of Contents
0 Executive summary
1 Introduction
1.1 Problem definition
1.2 Delimitations
1.3 Structure
2 Methodology
2.1 Research design
2.2 Development of the framework
2.3 Case study
3 Distress and bankruptcy
3.1 Definition of financial and economic distress
3.2 Default and bankruptcy
3.3 Characteristics of firms in distress or bankruptcy
3.4 Proceedings in financial distress and bankruptcy
3.5 Scope of this study
4 Option theory
4.1 Nature of an option
4.1.1 Generic option payoffs
4.1.2 Put-call-parity
4.1.3 Bull spread option strategy
4.2 Option pricing theory
4.2.1 Black- Scholes model in continuous time
5 Structural models
5.1 Firm value as a portfolio of options
5.2 Contingent claim pricing
5.3 Probability of default and credit risk assessment
5.4 Extended default-claim pricing
6 Framework
6.1 Discussion of valuation approaches
6.1.1 Income models
6.1.2 Liquidation models
6.2 Valuation uncertainty arising from distress
6.2.1 Structural uncertainty
6.2.2 Strategic uncertainty
6.3 Superiority of contingent claim pricing models
6.4 Estimation of model input variables
6.4.1 Risk-free rate
6.4.2 Default barrier
6.4.3 Debt maturity
6.4.4 Asset value
6.4.5 Asset volatility
6.5 Presentation
7 Case study
7.1 Company description
7.2 Framework applicability assessment
7.3 Macro and industry analysis
7.4 Strategic company analysis
7.5 Financial statement analysis
7.6 Capital structure analysis
7.7 Estimation of input variables
7.8 Contingent claim pricing
7.9 Probability of default
7.10 Discussion of model outputs
8 Limitations and future research
9 Conclusion
Research Objectives and Topics
This thesis aims to develop and apply a comprehensive, tractable framework for the evaluation of claims on distressed corporations by overcoming the shortcomings of traditional valuation methods through the use of structural models. The research seeks to answer how such a framework should be designed to be practically applicable and consistent with modern financial economic paradigms, and how it performs when applied to a real-life distressed company.
- Characterization of financial and economic distress
- Application of structural option pricing models to firm valuation
- Development of a 10-step sequential evaluation framework
- Case study implementation on the German air carrier Air Berlin
- Analysis of input variable sensitivity and model robustness
Excerpt from the Book
1.1 Problem definition
Consequently, this thesis investigates the following research question: How should a framework for the evaluation of claims in distressed firms be designed to (i) overcome the shortcomings of traditional valuation methods, (ii) ensure a practical applicability, and (iii) be consistent with paradigms of modern scientific financial economics? How does the framework perform once applied to a real-life distressed company?
In order to answer the above research question, this thesis examines the following sub-questions:
What are common characteristics of firms facing financial or economic distress and eventually bankruptcy? What are possible proceedings to overcome financial distress or bankruptcy? What is the rationale behind applying contingent claim pricing to the valuation of debt and equity in a firm? Which structural models have been proposed in academia? What are the shortcomings of traditional valuation techniques when applied to firms facing distress and bankruptcy and which factors contribute to the elevated uncertainty arising in a distressed environment? How would a framework need to be designed to implement contingent claim analysis in the valuation of distressed firms? In particular, how does the framework overcome the shortcomings of traditional valuation approaches? How can users of the framework estimate the necessary model input variables? For which prerequisites does the framework proposed above yield superior results in comparison to traditional valuation methods, and hence justifies its application? What are the fair values of the various debt and equity claims on Air Berlin using the proposed framework? What potential caveats accompany an application to a real-life company?
Summary of Chapters
1 Introduction: This chapter defines the research problem, establishing the need for improved valuation techniques for distressed firms and outlining the thesis structure.
2 Methodology: This chapter outlines the positivistic research philosophy, deductive approach, and the use of a case study to validate the developed framework.
3 Distress and bankruptcy: This chapter formally characterizes economic and financial distress, differentiates between them, and explores bankruptcy proceedings.
4 Option theory: This chapter provides the theoretical foundation for contingent claim pricing, covering option types, payoffs, and pricing paradigms.
5 Structural models: This chapter details how structural models use option theory to value corporate liabilities and assess default probability.
6 Framework: This chapter motivates and develops the 10-step evaluation framework for distressed firms, addressing estimation of model inputs.
7 Case study: This chapter demonstrates the practical application of the developed framework using the real-life example of Air Berlin.
8 Limitations and future research: This chapter discusses the limitations of the proposed framework and provides suggestions for future academic exploration.
9 Conclusion: This chapter summarizes the thesis, confirming that the framework offers a superior alternative to traditional methods for distressed firm valuation.
Keywords
Distressed firms, Corporate valuation, Structural models, Merton model, Contingent claim pricing, Financial distress, Bankruptcy, Default barrier, Asset volatility, Capital structure, Option pricing, Air Berlin, Credit risk, Reorganization, Debt instruments
Frequently Asked Questions
What is the core problem addressed by this thesis?
The thesis addresses the inadequacy of traditional income-based valuation methods when applied to firms in severe financial or economic distress, noting that these methods fail to account for the unique uncertainties and optionality inherent in distressed companies.
What are the primary fields of research involved?
The work combines research from asset pricing, corporate finance, and the specific study of financial/economic distress and bankruptcy proceedings.
What is the main objective of this study?
The primary goal is to develop and implement a 10-step sequential framework for the evaluation of claims on distressed firms using structural (Merton) models, ensuring it is practical and consistent with modern financial economics.
What scientific methodology is applied?
The study adopts a positivistic research philosophy with a deductive approach, consolidating existing academic research strands to construct the framework and applying it via a case study for empirical validation.
What is covered in the main body of the work?
The main part provides a theoretical foundation in option theory and structural modeling, followed by the development of the 10-step framework and its application to the distressed German air carrier Air Berlin.
Which keywords best characterize this work?
Distressed firms, corporate valuation, structural models, Merton model, contingent claim pricing, bankruptcy, default barrier, and capital structure.
How does the framework handle complex debt structures?
The framework utilizes a bull-spread option strategy to map different debt instruments and their varying seniorities, allowing for separate valuation of interest and principal components within the bankruptcy hierarchy.
Why was Air Berlin chosen for the case study?
Air Berlin was selected due to clear evidence of both financial and economic distress, as well as a complex corporate restructuring process that mirrors the structural and strategic uncertainties addressed by the developed framework.
- Quote paper
- Elias Fiebig (Author), Alexander Brandt (Author), 2017, Evaluation of claims on distressed firms. A conceptual framework based on structural models, Munich, GRIN Verlag, https://www.grin.com/document/377663
