Page 53 - Bankruptcy and Reorganization Services

The discounted cash flow (DCF) method is the most common form of discounting future benefit streams
and is calculated using the following framework:

1. Identify the number of years for the projection period.

2. Evaluate projected cash flows for the projection period.

3. Estimate the cost of capital.

4. Estimate the terminal value.

5. Adjust for ownership characteristics.

6. Adjust for nonoperating assets and liabilities.

Step 1: Identify the Number of Years for the Projection Period

There is no rigid rule for an appropriate length of projection period in an engagement involving a finan-
cially distressed company. Instead, the projection period should be determined by the specific facts and
circumstances surrounding the firm being valued. For companies going through a financial restructuring,
the projection period should encompass the period of the planned restructuring activities and should con-
tinue at least until the capital structure has reached a sustainable level of debt.

Step 2: Evaluate Projected Cash Flows for the Projection Period

Practitioners typically evaluate the projections prepared by management or a third party retained by
management. There are several cash flow metrics that management may use to estimate future cash
flows, and depending on the entity and its relative health (Chapter 11 versus Chapter 7, and so forth), it
will be up to the practitioner to determine whether management has used the proper cash flow measure-
ment and related assumptions to develop the estimate of future benefit. The following is a list of com-
mon financial metrics considered in the development of cash flow projections.

 Revenue Growth. Estimating a rate of revenue growth is generally an appropriate means of pro-
jecting future revenue for companies that are healthy and expanding, but it may not be a mean-
ingful exercise for companies in financial distress. Revenues of distressed firms are likely de-
pressed relative to historical levels. Growth will not always be positive in the near-term or even
in the long-term. If recent weak performance is the result of a cyclical downturn in the economy,
future revenue may not be dependent upon a business plan, but rather the economic cycle. In this
case, it is important to review the timing for an economic recovery and how revenue historically
has trended subsequent to cyclical downturns.

Consideration should be given to the effects of economic and industry cycles on the revenues of
distressed firms. Estimates of future revenue should reflect the current industry and economic
cycle. If current revenue is depressed due to an economic recession, higher growth rates may be
expected in near-term years if the economy is expected to improve. Alternatively, if a company
is experiencing financial distress notwithstanding a current economic boom, slower and even
negative growth rates may be reasonable during the projection period. Although it is very diffi-

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