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In the enterprise model of valuation, the firm's equity value is calculated by subtracting
the value of the firm's debt from the enterprise value. Debt valuation then becomes an
important component of a valuation of the firm's equity.
A company's debt is valued by calculating the payoffs that debt holders can expect to
receive, taking into account the risk of default. The default risk is addressed by
considering the probability of default and the amount that could be recovered in that
event. For modeling purposes, one may assume that the cash flow from the recovered
amount is realized at the end of the year of default.
Under this method, the value of the bond is the sum of the expected annual cash flows
discounted at the expected bond return:
The expected cash flow is the cash flow considering the probability of default:
E(cash flow) = π ( 1 + C ) F + ( 1 - π ) λ F
rdebt = rf + βdebtΠS&P500
where
If βdebt is not known, it can be found using ordinary least squares regression.
A firm's debt rating can change over time, and the value of future cash flows should take
into account the possibility of one or more rating changes. In this regard, bond valuation
can be modeled as a Markov Chain problem in which a transition matrix is constructed
for the probabilities of the firm's debt moving from one rating to another. For example, if
there are five possible ratings: A, B, C, D, E, and F; and πxy represents the probability of
moving from state x to state y, then the transition matrix would look like the following:
For multiple periods, the transition matrices for each period must be multiplied in order
to calculate the multi-period probabilities. This multiplication easily can be performed by
spreadsheet software.