The Undervaluation of Distressed Company's Equity

Frederik Schmidt

MPRA Paper from University Library of Munich, Germany

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.

Keywords: Distressed Company; Valuation; Derivatives Pricing Models (search for similar items in EconPapers)
JEL-codes: G12 G32 G33 G34 (search for similar items in EconPapers)
Date: 2009-02-09
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https://mpra.ub.uni-muenchen.de/13377/1/MPRA_paper_13377.pdf revised version (application/pdf)

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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:13341

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