The Undervaluation of Distressed Company's Equity

Schmidt, Frederik (2009): The Undervaluation of Distressed Company's Equity. Unpublished.

Abstract

In a simple firm value model we consider the impact of the insolvency probability on the valuation of equity and debt, which are assumed to be not publicly traded. For the case of a distressed company, which usually has high debt and low equity, we can show that the impact becomes increasingly important. Disregarding this yields an overvaluation of debt and an undervaluation of equity. We calculate the sensitivity of equity with regard to debt, which is isomorphic to the sensitivity of a call option with regard to the strike price, and show that this sensitivity rises with increasing debt. Furthermore, we provide a numerical example of this effect.

• Item Type: MPRA Paper
• Language: English
• Keywords: Distressed Company; Valuation; Derivatives Pricing Models
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates; G - Financial Economics > G3 - Corporate Finance and Governance > G34 - Mergers; Acquisitions; Restructuring; Corporate Governance; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy; Liquidation

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