Page 114 - Bankruptcy and Reorganization Services

erage the entity employs in its capital structure. fn 3 Since the concept was first introduced, there have
been adjustments to the approach to capture more "real world" variables like income taxes. The ap-
proach used by practitioners today calculates the value of an entity assuming no leverage and then in-
corporates the present value of any tax shields that result from interest expense. This is especially help-
ful when a debtor’s ability to utilize the tax benefits of interest expense may be deferred to current pret-
ax losses.

The APV technique is typically used as part of a discounted cash flow methodology and may represent
an appropriate and efficient method of assessing a debtor’s reorganization value. Although an income
approach utilizing APV is not typically relied upon as a primary approach in bankruptcy settings, it can
be a very useful technique to validate the assumptions used in the income and market approaches. Some
consider APV to be most relevant for business reorganizations that tend to be more financial in nature
and less relevant for business reorganizations that are more operational in nature. An additional benefit
of applying APV is that it provides an effective means of addressing the value of the reorganized debt-
or’s NOL and the tax benefit of interest expense.

An alternative, but closely related, technique that can be employed to discount cash flows in situations
where capital structures are changing over time is capital cash flows. The capital cash flows approach
was introduced by Richard S. Ruback as set forth in his paper "Capital Cash Flows: A Simple Approach
to Valuing Risky Cash Flows." fn 4

Use of Net Operating Losses by the Reorganized Debtor and IRC Section 382

An interesting issue relating to the estimate of cash flow from operations that frequently arises in a
bankruptcy setting is the availability and use of NOL carryovers. In general, NOL carryovers may be
utilized to reduce taxable income, thereby enhancing cash flow. However, in an effort to limit an entity’s
ability to acquire a loss corporation and utilize its NOL, Congress enacted IRC Section 382. In particu-
lar, IRC Section 382(a) limits the use of an NOL if a loss corporation has experienced a "change of
ownership." fn 5 The limitation introduced by Section 382(a) restricts the amount of income against
which a "prechange" NOL can be applied in any "postchange" taxable year to the product of the value of
the loss corporation immediately before the ownership change and the "long-term tax-exempt rate." fn 6
Any net operating loss not used because of insufficient eligible taxable income in a given year is added
to the IRC Section 382(a) limitation of a subsequent year. In essence, the limitation enables the new
owners to use NOL carryovers to offset an amount of income equal to a hypothetical stream of income

fn 3 F. Modigliani and M. H. Miller, "The Cost of Capital, Corporate Finance, and the Theory of Investment," American Economic
Review 48 (June 1958): 261–297.
fn 4 Richard S. Ruback, "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows," Financial Management 31, no. 2
(Summer 2002): 85–103.

fn 5 In general, there is a change in ownership if, immediately after any owner shift involving a 5% shareholder or any equity shift, the
percentage of the stock of the loss corporation owned by one or more 5% shareholders has increased by more than 50 percentage
points over the lowest percentage of stock of the loss corporation (or any predecessor corporation) owned by such shareholders at any
time during the three-year period ending on the day of any ownership change. For further discussion on changes in ownership refer to
IRC Section 382(g).

fn 6 In general, the long-term tax-exempt rate is the highest of the adjusted federal long-term rates in effect for any month in the three-
calendar-month period ending with the calendar month in which the change date occurs.

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