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Insolvency risks in company valuations

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It is not currently possible to estimate the economic damage caused by the Corona virus. What is clear, however, is that companies in all kinds of sectors have seen a serious collapse in revenues and profits and are therefore faced with existential challenges. For potential buyers and also sellers, it is therefore necessary to adequately consider a potential insolvency risk as part of company valuations. Decisions should not be made on the basis of inflated company values.

 

Scope of application

In principle, it is assumed that the risk of cashflow shortfalls due to defaults will rise along with an increasing level of debt. Studies by various rating agencies show that, as a rule defaults are only likely to occur with “non-investment” grade ratings. Thus, the scope of application can be restricted to the valuation of companies with high levels of debt.

 

Methodological consideration

The company value is calculated technically by capitalisation of the cash flows of the company concerned. The starting point for the consideration of insolvency risks therefore involves both cash flows and the capitalisation factor.


The planned cash flows should regularly have probability rates assigned to them, and be the result of multi-dimensional planning. As a result, as far as possible all realistic future expectations are modelled, and insolvency risks are also included by implication.


In practice, this is not normally the case as planning usually serves strategic management and defines target values. The planning must therefore be adapted to include insolvency risks. The adjustment should take place through the inclusion of accumulated period-specific default probabilities.
 
In this process, a distinction must be methodically made between an adjustment of the cash flow in the detailed planning phase and that of the terminal value. In the detailed planning period, the period-specific planned cash flow is reduced by the cumulative default probability for the respective period. In the terminal value, the period-specific default probability is considered in the form of a negative growth rate.


It is furthermore necessary to adjust the capitalisation factor, consisting of cost of equity and cost of debt. Cost of equity already reflects entrepreneurial risk through the beta factor. On the other hand, cost of debt still needs to be adjusted. The contractually agreed and/or market listed cost of debt needs to be corrected for the period-specific default probability. This adjustment of the cost of debt also results in a lower expected value of the tax-related relief from debt financing (known as Tax Shield).

 

Quantifying the insolvency risk

Various options are described in literature for deriving a risk of default (for example, Monte-Carlo simulation or rating-based methods).

 

Due to their high level of objectivity and standardisation, rating-based methods are given priority in practice. For small and medium-sized companies, it is possible to work with synthetic ratings due to the absence of external ratings in most cases.

 

Analogous to the derivation of the beta factor for cost of capital analysis, peer companies are also used for synthetic ratings. Criteria for the selection of the peer companies may be financial performance indicators (e.g. equity ratio, total return on capital, interest rate and likelihood of repayment) as well as sector and region. The resulting rating for the benchmark group should be derived for a specific period. It can thus be considered that performance indicators (e.g. equity ratio) change during planning. Quantifying the risk of default is finally achieved by converting the respective rating into probabilities of default. The rating agencies regularly provide publicly available data records for this purpose. When converting rating classes it should be ensured that the geographical area and sector of the object being valued are taken into account. Otherwise, it can lead to a distortion of the default risk e.g. due to different insolvency rules per jurisdiction.

 

Conclusion

In view of the increasing level of debt in many companies, and the associated increase in the threat of default, the insolvency risk should be included as part of any company valuation. The level of the insolvency risk is determined by a probability of default specific to the time period and the individual company. Both cash flows and the cost of capital need to be adjusted accordingly.


What effect the inclusion of the insolvency risk may have on the value will vary case by case. We would particularly like to point out that it is firstly necessary to analyse to what extent opportunities and risks have already been adequately included, in a balanced way, in the planning of the entity being valued. 

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