Page 84 - Bankruptcy and Reorganization Services

Chapter 12

Valuation of Liquidated Debt in the Context of Financial Distress and Bankrupt-
cy

A comprehensive discussion of the valuation of liquidated debt is beyond the scope of this practice aid.
This section is meant to provide a summary-level discussion of the basic methodology of valuing liqui-
dated debt and some of the issues involved when valuing distressed liquidated debt. The following dis-
cussion contemplates an assessment under a value in exchange premise. All references to debt in the
section relate to liquidated debt.

The valuation of debt is a central issue in bankruptcies. The inability of a company to service its debt is
the essential reason that companies enter into bankruptcy. The value of debt is used to determine the
value of equity securities and to negotiate recoveries for the various parties in a bankruptcy proceeding.
It is important to correctly determine the value of debt issued as part of a plan of reorganization or re-
structuring to be able to assess the fairness of the plan and the recoveries to the various parties.

The face value, or par value, of debt is often used as a shorthand estimate for the market value of debt.
This estimate may occasionally be accurate for financially healthy companies with recently issued debt.
However, even when the value of debt is equal to par at issuance, the market value can subsequently
change over time as interest rates fluctuate and as the issuer’s credit quality changes. Debt issued as part
of a plan of reorganization or restructuring frequently carries a coupon rate that is below the market
yield for the issuer’s credit quality. This generally causes the market value of the debt to be below par
value, which may be directly observable in the market.

Debt is generally valued using an income approach applying the discounted cash flow methodology. The
scheduled principal and interest payments are discounted back at the market yield for the debt.

The yield for the debt should reflect the required yield for debt of a similar credit quality with compara-
ble terms and maturity. Generally, the appropriate yield can be benchmarked from comparable publicly
traded debt. Once multiple comparable debt instruments are identified, the practitioner typically must
make adjustments for differences in the subject debt and the identified comparable debt instruments.

Adjustments may also be necessary to reflect differences in liquidity between the subject debt and the
publicly traded debt used to benchmark the yield. The lack of a ready market for the subject debt will
generally reduce the value of the debt relative to the publicly traded equivalent debt. The adjustment for
illiquidity can be accomplished by adjusting the yield upward or applying a discount to the value derived
from the discounted cash flow. Adjustments for illiquidity in a debt valuation are typically less than the
adjustments observed in an equity valuation.

The market yield for the debt can also be estimated by assessing the pro forma credit rating of the debt
and obtaining market yields for similar publicly traded debt with the same rating. The general credit rat-
ing criteria used by the independent credit rating agencies can be used as a guide to estimate what the
credit rating would be for the subject debt. The yields on publicly traded debt with a similar credit rating
and comparable terms and maturity can be used to estimate the market yield for the subject debt. As
previously noted, adjustments may also be necessary to reflect differences in liquidity between the sub-
ject debt and the publicly traded debt used to benchmark the yield.

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