Page 54 - Bankruptcy and Reorganization Services

cult to predict economic cycles, current macroeconomic assumptions should be incorporated in
the valuation of a distressed firm. fn 12

The company may also be experiencing a downturn in revenue because of regulatory changes or
increased competition for the company’s products. Such conditions present particular challenges
in developing estimates of future revenue and must be carefully evaluated on a case-by-case ba-
sis.

If the company is operating in or contemplating a Chapter 11 filing, the analyst must evaluate
whether the company may lose additional revenues if a Chapter 11 filing occurs. If the compa-
ny’s plan of reorganization includes the sale of certain assets or divisions, the revenues from
these assets or divisions should be removed from the projections.

For a company in bankruptcy, revenue growth may be significantly affected by restructuring ac-
tivity during the explicit forecast horizon. Revenue growth may be highly volatile during this pe-
riod.

As a result of the aforementioned conditions, it may not be possible to develop meaningful esti-
mates of future revenue from historical trends. Instead, it may be necessary to develop revenue
estimates from the ground up, based on reasonable volume estimates for primary product catego-
ries and estimates of per-unit prices that consider, among other things, the anticipated timing for
an economic recovery, changes in the regulatory environment and competitive landscape, and the
operational and financial restructuring contemplated. fn 13

 Operating Profit or EBIT. Most distressed situations result in a combination of both financial
and operational restructuring. Nonrecurring charges and nonoperating charges should be stripped
from the analysis in order to determine a more appropriate level of operational activity. If a firm
is distressed, nonrecurring costs will likely include some level of restructuring costs, professional
fees, and financing fees. If additional operational restructuring is planned, both the costs of the
operational restructuring and cost-cutting measures should be incorporated into the projections.

After a thorough assessment of historical operating performance is implemented and necessary
adjustments have been made, the foundation has been set to begin the process of estimating a
company’s future operating performance. Numerous factors can affect future operating profit
margins, which will not necessarily be favorable when compared to historical operating profit
margins. As with revenue growth, the margins of companies in bankruptcy can be highly volatile
during the restructuring phase and may have little resemblance to historical margins.

 Tax Rate. If the projections have been normalized, the marginal tax rate is typically used
throughout the entire projection period. Although it may be appropriate to use an effective rate in
the early years if book or tax differences are identifiable and significant, the projections should
generally reflect the marginal tax rate by the end of the projection period.

fn 12 The approach taken by some practitioners is to reflect increased risk associated with earnings volatility due to cyclicality in the
discount rate.

fn 13 The availability of sufficiently reliable and detailed financial information will impact the analyst’s ability to develop revenue es-
timates from the ground up.

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