Bankruptcy Risk in Discounted Cash Flow Equity Valuation

Kenth Skogsvik (), Stina Skogsvik and Henrik Andersson
Additional contact information
Kenth Skogsvik: Department of Accounting, Stockholm School of Economics, Sveavägen 65, Box 6501, 113 83 Stockholm, Sweden
Stina Skogsvik: Department of Accounting, Stockholm School of Economics, Sveavägen 65, Box 6501, 113 83 Stockholm, Sweden
Henrik Andersson: Department of Accounting, Stockholm School of Economics, Sveavägen 65, Box 6501, 113 83 Stockholm, Sweden

JRFM, 2023, vol. 16, issue 11, 1-18

Abstract: We investigate the importance of bankruptcy risk in discounted cash flow (DCF) equity valuation. Our analyses first show how bankruptcy risk is incorporated in DCF valuation, where investment risk is captured by cash flow certainty equivalents . Within this general setting, we find that bankruptcy risk can be captured by discounting factors incorporating period-specific bankruptcy probabilities, allowing the numerators in a DCF valuation model to follow a binary random walk . Elaborating a model of this kind, we assess the value of the equity holders’ limited liability right (the equity holders’ right to hand over the firm to its creditors if bankruptcy occurs). Two valuation models commonly used in academic research and professional practice—the Dividend Discount Model ( DDM ) and the Residual Income Valuation ( RIV ) model—are addressed specifically. Our analyses show that bankruptcy probabilities are important for the estimation of the value drivers in both models. Even if bankruptcy probabilities are as low as 0.02, equity values might be severely exaggerated if bankruptcy risk is ignored in DDM or RIV. In particular, this holds for firms expected to have high future growth (conditioned on firm survival). For the RIV model to properly capture bankruptcy risk, we identify “ bankruptcy event accounting principles ” and an additional term that must be included in the model. We also show that bankruptcy risk under certain conditions can be handled through a specific calibration of the discounting rate/-s in all DCF models, allowing the value drivers—i.e., future dividends or residual income—to be forecasted conditioned on firm survival .

Keywords: bankruptcy risk; DCF; dividend discount model; discounting rate; equity valuation; financial distress; fundamental valuation; limited liability right; residual income valuation (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
https://www.mdpi.com/1911-8074/16/11/476/pdf (application/pdf)
https://www.mdpi.com/1911-8074/16/11/476/ (text/html)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:gam:jjrfmx:v:16:y:2023:i:11:p:476-:d:1275805

Access Statistics for this article

JRFM is currently edited by Ms. Chelthy Cheng

More articles in JRFM from MDPI
Bibliographic data for series maintained by MDPI Indexing Manager ().