Page 82 - Bankruptcy and Reorganization Services

timal capital structure should be considered, given the existing financial market conditions. The optimal
capital structure is typically assumed to be the average capital structure for companies in the industry.
This is based on the premise that there will be an efficient allocation of capital by investors across the
industry as a whole. Proxy capital structures from industry data can also be useful in determining the op-
timal amount of debt and equity.

Plan of Reorganization Capital Structure

As stated previously, if the purpose of the valuation is to determine the reorganized value of the business
as part of a Chapter 11 restructuring, the capital structure called for in the plan is typically used. The
capital structure called for in the plan, although not necessarily optimal, is generally considered to be
reasonable and feasible for the company at plan confirmation because it has been negotiated through the
Chapter 11 process and approved by the court. When the capital structure called for in the plan is used to
calculate the WACC, the actual interest rates stipulated in the plan should generally be used to calculate
the WACC, at least as of the confirmation date.

Adjustments may need to be made for any unique debt terms called for in the plan. Of course, if the val-
uation is being performed as part of the plan negotiations, and the terms of the plan have not been agreed
upon yet, the analyst will need to determine the optimal capital structure for the WACC. It should be
noted that the capital structure called for in the plan is not always the industry capital structure or a long-
term, stable capital structure. The plan will often call for a continued deleveraging of the company over
a period of time after emergence from bankruptcy. The anticipated deleveraging may result in changing
interest rates as the debtor’s balance sheet improves. The analyst should evaluate the stability of the cap-
ital structure based upon the terms of the plan. It is generally appropriate to assume that the company’s
capital structure will approach the industry average capital structure, and industry borrowing rates, by
the end of the discrete forecast period in the plan.

If the purpose of the valuation is to determine the value of a minority interest, then the actual capital
structure of the firm is sometimes assumed to be appropriate because a minority interest holder does not
have the ability to alter the company’s capital structure. If the subject company is in financial distress,
the sustainability of the actual capital structure will need to be evaluated. Although a minority interest
holder may not be able to cause a change to the capital structure, the creditors of the company often do.
Over the long run, creditors, investors, or management may correct the capital structure. The long-term,
sustainable capital structure should therefore be considered along with the actual capital structure when
calculating the WACC.

As noted elsewhere in this practice aid, leverage will affect the timing of the utilization of an NOL car-
ryover. Companies in financial distress often have debt levels so high that interest expense can be great-
er than EBIT. In this case, there will be no taxable income remaining after interest expense to utilize an
NOL carryover. Accordingly, if the company’s leverage does not change, the NOL may have little or no
value. Higher levels of debt will lower the value of an NOL, all else being equal, because interest ex-
pense reduces the taxable income that gives an NOL carryover value. Higher levels of interest expense
will defer the utilization of an NOL carryover. The deferral reduces the present value of the tax benefit
and, if deferred long enough, can cause the NOL to expire. When estimating the value of an NOL, the
analyst should therefore consider what the appropriate capital structure is to use. The selection of which
capital structure to assume will affect the estimated value of the NOL. Generally, the appropriate capital
structure to use when estimating the value of an NOL will be the same capital structure used to estimate
the WACC. The preceding discussion regarding which capital structure to assume for the WACC is also
applicable to evaluating the capital structure to assume in the NOL valuation.

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