When calculating enterprise value (EV = equity value + debt - cash), why do we use the market value of debt for distressed companies? Is the underlying assumption that the company can buy back its debt on the open market? Or is the idea that we should be considering what the market believes the value of the core assets of the business is worth? Any help would be greatly appreciated
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When calculating EV in theory you should always use market values of Equity and Debt but usually you would assume that market value of debt = book value of debt if the company is stable and this makes sense. But for the distressed business, the market value of debt is likely to be substantially lower than the book value. So you can't just approximate market value of debt by its book value in this case.
Appreciate the comment. So why are we using market value of debt when calculating EV in the first place? It makes sense that we use market value of equity because book value doesn’t capture the company’s future growth, but can’t seem to think of why we’d use market value of debt.
You can apply similar logic to debt. You should use market value because it reflects the real value of debt and when we calculate EV we want to see the market value of the whole business, not some accounting value of the firm. Sorry, not sure how to phrase it properly
If the company's value has deteriorated, that gets reflected in the market value of debt. If you only use book value, you are not reflecting the fact that this business has deteriorated.
Kind of confused by the above comments - Almost everyone I know in banking and PE uses principal value of debt not market value. Given equity value is 0 until you repay outstanding debt you generally assume that you pay the entire outstanding obligation. Market value of debt will differ based on treasury rates and how those affect relative yields for past issuances but at the end of the day you have to pay back that full principal amount before aby value accrues to equity holders.
Disagree with a couple points here...
In the context of distressed companies (as the OP mentions), the market value of their debt has nothing to do with treasury rates. This pricing dynamic changes when a company becomes distressed. For example, a distressed company 's senior secured loan may be trading at 85, their senior subordinated trades at 55, and junior subordinated at 20. These market prices reflect: the probability of the company entering into restructuring, likelihood of company defaulting on the debt, expected recovery for the debt holders of that specific security, likelihood of the debtholders receiving any recovery.
Furthermore, the company may not have to pay back the debt in full before any value accrues to the equity holders. The distressed company will likely seek to restructure their debt, either in-court (i.e. Chapter 11) or out-of-court, and settlements for these debt holders will vary based on negotiations (debt to equity swaps, amend and extend, refi, etc.). Even in these scenario's, the equity still continues to trade at a positive value, albeit very little. This is odd because when junior subordinated debt trades at 20 its highly unlikely they're getting out in full, and therefore equity value is technically $0 based on absolute priority, and herein lies the inconsistencies of distressed debt pricing.
OP here - thanks for the input. So to clarify, would the reason why we use market value when calculating EV for distressed companies be to reflect the things you mentioned (the probability of the company entering into restructuring, likelihood of company defaulting on the debt, expected recovery for the debt holders of that specific security, likelihood of the debtholders receiving any recovery)? Would another reason be that we want to get a sense of what the market value of the core assets of the business is?
It depends on what you're trying to determine with your valuation. when building capitalization tables, restructuring shops typically apply the absolute priority rule, using face values of all debt senior to the specific claim + market value of the current claim to calculate TEVs (or in general, value through that specific tranche). This is because theoretically if you're applying any value, distressed or not, to a specific tranche, under the absolute priority rule the claims senior to the tranche must have received full recovery. But this is a different concept than what other uses for TEV calculations are / how they teach you it in school
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