Evaluation of claims on distressed firms. A conceptual framework based on structural models

Table of Contents

0 Executive summary

1 Introduction

1.1 Problem definition

1.2 Delimitations

1.3 Structure

2 Methodology

2.1 Research design

2.2 Development of the framework

2.3 Case study

3 Distress and bankruptcy

3.1 Definition of financial and economic distress

3.2 Default and bankruptcy

3.3 Characteristics of firms in distress or bankruptcy

3.4 Proceedings in financial distress and bankruptcy

3.5 Scope of this study

4 Option theory

4.1 Nature of an option

4.1.1 Generic option payoffs

4.1.2 Put-call-parity

4.1.3 Bull spread option strategy

4.2 Option pricing theory

4.2.1 Black- Scholes model in continuous time

5 Structural models

5.1 Firm value as a portfolio of options

5.2 Contingent claim pricing

5.3 Probability of default and credit risk assessment

5.4 Extended default-claim pricing

6 Framework

6.1 Discussion of valuation approaches

6.1.1 Income models

6.1.2 Liquidation models

6.2 Valuation uncertainty arising from distress

6.2.1 Structural uncertainty

6.2.2 Strategic uncertainty

6.3 Superiority of contingent claim pricing models

6.4 Estimation of model input variables

6.4.1 Risk-free rate

6.4.2 Default barrier

6.4.3 Debt maturity

6.4.4 Asset value

6.4.5 Asset volatility

6.5 Presentation

7 Case study

7.1 Company description

7.2 Framework applicability assessment

7.3 Macro and industry analysis

7.4 Strategic company analysis

7.5 Financial statement analysis

7.6 Capital structure analysis

7.7 Estimation of input variables

7.8 Contingent claim pricing

7.9 Probability of default

7.10 Discussion of model outputs

8 Limitations and future research

9 Conclusion

Research Objectives and Topics

This thesis aims to develop and apply a comprehensive, tractable framework for the evaluation of claims on distressed corporations by overcoming the shortcomings of traditional valuation methods through the use of structural models. The research seeks to answer how such a framework should be designed to be practically applicable and consistent with modern financial economic paradigms, and how it performs when applied to a real-life distressed company.

• Characterization of financial and economic distress
• Application of structural option pricing models to firm valuation
• Development of a 10-step sequential evaluation framework
• Case study implementation on the German air carrier Air Berlin
• Analysis of input variable sensitivity and model robustness

Excerpt from the Book

Summary of Chapters

1 Introduction: This chapter defines the research problem, establishing the need for improved valuation techniques for distressed firms and outlining the thesis structure.

2 Methodology: This chapter outlines the positivistic research philosophy, deductive approach, and the use of a case study to validate the developed framework.

3 Distress and bankruptcy: This chapter formally characterizes economic and financial distress, differentiates between them, and explores bankruptcy proceedings.

4 Option theory: This chapter provides the theoretical foundation for contingent claim pricing, covering option types, payoffs, and pricing paradigms.

5 Structural models: This chapter details how structural models use option theory to value corporate liabilities and assess default probability.

6 Framework: This chapter motivates and develops the 10-step evaluation framework for distressed firms, addressing estimation of model inputs.

7 Case study: This chapter demonstrates the practical application of the developed framework using the real-life example of Air Berlin.

8 Limitations and future research: This chapter discusses the limitations of the proposed framework and provides suggestions for future academic exploration.

9 Conclusion: This chapter summarizes the thesis, confirming that the framework offers a superior alternative to traditional methods for distressed firm valuation.

Keywords

Distressed firms, Corporate valuation, Structural models, Merton model, Contingent claim pricing, Financial distress, Bankruptcy, Default barrier, Asset volatility, Capital structure, Option pricing, Air Berlin, Credit risk, Reorganization, Debt instruments

Frequently Asked Questions

What is the core problem addressed by this thesis?

The thesis addresses the inadequacy of traditional income-based valuation methods when applied to firms in severe financial or economic distress, noting that these methods fail to account for the unique uncertainties and optionality inherent in distressed companies.

What are the primary fields of research involved?

The work combines research from asset pricing, corporate finance, and the specific study of financial/economic distress and bankruptcy proceedings.

What is the main objective of this study?

The primary goal is to develop and implement a 10-step sequential framework for the evaluation of claims on distressed firms using structural (Merton) models, ensuring it is practical and consistent with modern financial economics.

What scientific methodology is applied?

The study adopts a positivistic research philosophy with a deductive approach, consolidating existing academic research strands to construct the framework and applying it via a case study for empirical validation.

What is covered in the main body of the work?

The main part provides a theoretical foundation in option theory and structural modeling, followed by the development of the 10-step framework and its application to the distressed German air carrier Air Berlin.

Which keywords best characterize this work?

Distressed firms, corporate valuation, structural models, Merton model, contingent claim pricing, bankruptcy, default barrier, and capital structure.

How does the framework handle complex debt structures?

The framework utilizes a bull-spread option strategy to map different debt instruments and their varying seniorities, allowing for separate valuation of interest and principal components within the bankruptcy hierarchy.

Why was Air Berlin chosen for the case study?

Air Berlin was selected due to clear evidence of both financial and economic distress, as well as a complex corporate restructuring process that mirrors the structural and strategic uncertainties addressed by the developed framework.