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The Undervaluation of Distressed Company's Equity

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Author Info
Schmidt, Frederik
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.

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Publisher Info
Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 13341.

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Date of creation: 09 Feb 2009
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Handle: RePEc:pra:mprapa:13341

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Related research
Keywords: Distressed Company; Valuation; Derivatives Pricing Models;

Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure
G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June. [Downloadable!] (restricted)
  2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May. [Downloadable!] (restricted)
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