Page 85 - Bankruptcy and Reorganization Services

Generally, the interest rate on debt can be either fixed or floating. In the case of fixed-rate debt, schedul-
ing out the interest payments is straightforward. The coupon payments are calculated based on the fixed
rate times the outstanding principal. For floating-rate debt, the scheduled interest payments should be
based on the expected floating rate at each interest payment date. The expected rate can be derived from
publicly available forward rates or similar market-based projections. The contractual floating rate will
often be based on a base rate, such as the London Interbank Offered Rate (LIBOR) or the prime rate,
plus or minus an adjustment factor. These terms should be obtained from the debt agreement or a relia-
ble source such as a final term sheet.

Debt that does not require periodic interest payments to be made is known as zero coupon debt. A zero
coupon debt is repaid at face value at the maturity date. Because there are no coupon interest payments
made on zero coupon debt, the interest is included in the face value that is paid at maturity. Accordingly,
the market value of a zero coupon debt instrument is always below par until maturity. The difference be-
tween the market value at any point in time and par value reflects the interest that is to be earned on the
debt over the remaining time to maturity. The market value of zero coupon debt is very sensitive to the
market yield. The value of a zero coupon debt is based on the single payment, at par, to be received at
maturity, discounted at the appropriate market yield to maturity.

The valuation of debt for a company in bankruptcy or financial distress presents significant challenges.
When a company is in financial distress, its ability to make scheduled interest and principal payments
becomes uncertain or even unlikely. This can make it difficult or even impossible to apply a traditional
income approach. Moreover, the yields on publicly traded distressed debt can be very inconsistent be-
tween comparable debt instruments. The market for distressed debt is often illiquid, which can result in
unreliable yield information. In some cases, yields on short-term maturities can be higher than long-term
maturities due to the imminence of default. The wide range of observed yields on distressed debt can
make it difficult to determine the appropriate yield to apply to the subject debt.

Where the ability to make scheduled interest and principal payments is doubtful, the estimated recovery
through a restructuring or liquidation becomes an important factor to estimate value. In this case, the
terms of the debt instrument, such as collateral, guarantees, and default remedies, become critical con-
siderations in a valuation. The facts and circumstances associated with each debt issue can drive value
differences, which is also a source of the volatility of observed yields on distressed debt.

As an alternative to the traditional income approach to value distressed debt, many analysts focus on
valuing distressed debt by estimating the percentage recovery to debt holders through the sale of the un-
derlying collateral or the business as a whole. This method is appropriate under certain circumstances
but can easily be misapplied. First, the debt holder must have the ability to force the sale of the collateral
or the business for this approach to be appropriate. Moreover, if the recovery strategy is a forced sale or
liquidation of the company, then the analyst should estimate the value of the proceeds on a forced or liq-
uidation basis. The timing of the receipt of any proceeds should also be considered. The process of exer-
cising rights under debt covenants can be protracted, which can further diminish the recovery value of
the debt using this approach. fn 1

fn 1 Unique rights and features of the debt, such as conversion rights and liquidation preferences, can have a significant effect on the
value of the debt. A discussion of complex debt instruments is beyond the scope of this practice aid.

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