Corporate Valuation under COVID-19
Leestijd 11 minuten
Prof. Dr. Bernhard Schwetzler, CVA
‘I will concentrate on some conceptual and “technical” problems.’
The pandemic outbreak of the COVID-19 virus has locked down entire countries, disrupted flows of goods and trade and broken well established business models. Capital markets worldwide have been reacting (and still react) very nervous on any news related to the pandemic. Transaction volume on M&A markets went down by more than 50% compared to 2019.
In this article I will discuss some implications and open questions related to the pandemic and it´s consequences for corporate valuation. By doing so I will concentrate on some conceptual and “technical” problems.
Bankruptcy risk and bankruptcy costs
It is expected that the negative economic impact of covid19 will yield a significant increase of future corporate bankruptcies.” Thus this increased bankruptcy risk needs to be reflected in the valuation procedure. Technically there are two different ways to do this:
- The “direct” approach splits the future cash flows into two different outcomes, the firm either going bankrupt (with a probability of p) or continuing operations (with 1-p). After bankruptcy the firm will be liquidated, generates potentially a liquidation cash flow and delivers no further cash flows. If p is assumed to be constant over time, the probability of survival until period t is equal to (1 – p)”; thus p is effectively working as a negative growth rate.
- The indirect approach rests on the well-known APV and extends it by subtracting the cost of bankruptcy as a third component. The total firm value is the sum over the value of the all-equity financed firm, the value of the debt related tax savings (Tax shield) minus the value of the costs of financial distress. The latter ones represent the present value of all additional losses in value caused by the firm slipping into a crisis:3 Losses due to forced fire-sales of assets, customers and well-trained employees leaving. Their value is calculated by combining the losses when getting into a crisis with the probability
of slipping into a crisis over a given time frame.
For both models you need the probability for bankruptcy/financial distress as an input. These data can either be acquired from a rating agency selling cumulated default probabilities for a given debt time to maturity and rating. Alternatively the valuator can estimate this probability by combining operating risk properties, capital structure and debt time to maturity for the firm to be valued based on stochastic models. Whereas the direct approach requires an estimate of the liquidation cash flow/value of the firm, the indirect approach needs an estimate for additional value losses when slipping into a crisis. Here the valuator can rely on established empirical research results from capital structure theory where bankruptcy costs are an important factor.
The value of debt under COVID-19
The expected increase in bankruptcy risk will also have an impact on the value of debt. Increasing default probabilities may reduce the market value of the outstanding interest and redemption payments and potentially create a wedge between market and book value of debt. Whether this is the case however depends on some clauses in the debt contract itself: If the creditor is allowed to react on the increase of credit risk, e.g. by charging a higher interest
rate, an adjustment of the debt value itself is not necessary. If the creditor does not have the opportunity to adjust credit conditions, then the market value has to be adjusted. Recalculating the value of debt shall include the higher default risk; option pricing models are helpful here.
It is important to note that this adjustment will only affect the debt currently outstanding. Any new credit negotiated in later years will fully reflect the (then prevailing) market conditions and thus have no material impact on the current value of the firm.4 Thus the effect on the current market value of debt will depend on the remainder time to maturity. For shorter time to maturities it will be of minor importance.
The decrease in debt value caused by COVID-19 will by the same token increase the value of the equity holders. However in the vast majority of cases the negative impact of COVID-19 on the total firm value will be much higher, so that in total equity values are also significantly declining.
The value of cash under COVID-19
Finally COVID-19 may also change the way how valuators look at cash holdings: cash at hands may allow to cover losses and avoid bankruptcy (and the costs related to it.) Financial theory also provides some valuable insights here: Studies show that the value contribution of cash holdings depends on the accessibility of funding sources (access to equity/debt markets, owners with deep pockets) and investment opportunities; a high cash balance is more valuable for firms that do not have easy access to fresh funds and that have good growth opportunities.