Page 113 - Bankruptcy and Reorganization Services

The indirect costs of financial distress, on the other hand, are difficult to measure. As an entity begins
experiencing financial distress, the attention of company personnel is diverted from managing assets and
analyzing investment decisions to battling with and appeasing claimants. This diversion of attention is
manifest in reduced asset utilization, increased expenses, employee turnover, and lost business opportu-
nities. The impact of these factors on the value of the debtor represents the indirect costs of financial dis-
tress.

Although the indirect costs of financial distress exist prior to bankruptcy, they may be exacerbated once
the entity files for bankruptcy. This may occur for two primary reasons. First, the diversion of attention
mentioned in the previous paragraph may be intensified. Second, the revenues of the entity may be im-
paired due to reluctance on the part of customers and suppliers to conduct business with an entity in
bankruptcy.

By the time the parties in a bankruptcy proceeding are seeking approval of a plan of reorganization,
many costs of financial distress may already be reflected in the current operating performance of the
debtor. In fact, if the bankruptcy proceeding is moving toward a successful reorganization of the debtor,
many improvements in the debtor’s operations may have already been implemented, thereby eliminating
many of the costs of financial distress. Upon successful reorganization, the direct costs of financial dis-
tress are reduced and may eventually be eliminated. Accordingly, care must be given to eliminate bank-
ruptcy administration costs that will not be incurred on a go-forward basis.

Although the reorganized entity may shed itself of the indirect costs of financial distress, the indirect
costs will not be eliminated as quickly as the direct costs. Some of these costs may persist for many
years subsequent to the approval of the plan of reorganization. It is always important for the practitioner
to substantiate the value estimate based on the underlying economics. However, the need for underlying
support is rarely more acute than it is in the context of a business reorganization. This is the case be-
cause in many instances estimated future performance may differ significantly from historical perfor-
mance.

Adjusted Present Value (APV) and Capital Cash Flows

As indicated previously, companies in financial distress often experience changes in their capital struc-
ture over time. As a result, when developing an appropriate discount rate to employ when assessing a
debtor’s reorganization value, it may be necessary to estimate a different WACC each year to reflect the
possibility of a company’s capital structure changing over time. An alternative to estimating a different
WACC each year would be to employ a technique called adjusted present value (APV) in the valuation
process. APV was introduced by Stewart C. Myers in March 1974. fn 2 The technique, stated in its most
basic terms, is to value the entity assuming no financial leverage (no debt in the capital structure) and
then adjust the entity’s value for, among other things, the present value of tax shields and the costs of fi-
nancial distress. Thus, the discount rate employed would be the debtor’s unlevered cost of capital.

The premise for starting with the value of the unlevered entity (assuming no debt in the capital structure)
is that an entity’s opportunity cost of capital remains constant regardless of the amount of financial lev-

fn 2 S.C. Myers, "Interactions of Corporate Financing and Investment Decisions—Implications for Capital Budgeting," Journal of
Finance 29, no. 1 (March 1974): 1–25.

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