Valuing Interest-Bearing Debt  345 of the debt—typically based on the company’s bond rating. The book value of debt is a reasonable approximation for fixed-rate debt if interest rates and de- fault risk have not significantly changed since the debt issuance. For floating- rate debt, value is not sensitive to interest rates, and book value is a reasonable approximation if the company’s risk of default has been generally stable. If you are using your valuation model to test changes in operating perfor- mance (for instance, a new initiative that will improve operating margins), the value of debt under your new assumptions may differ from its current market value. Always check leverage ratios, such as the interest coverage ratio, to test whether the company’s bond rating will change under the new forecasts; often it will not. A change in bond rating can be translated into a new yield to maturity for debt, which in turn will allow you to revalue the debt. For more on debt ratings and interest rates, see Chapter 33. Highly Levered Companies  For companies with significant debt or compa- nies in financial distress, valuing debt requires careful analysis. For distressed companies, the intrinsic value of the debt will be at a significant discount to its book value and will fluctuate with the value of the enterprise. Essentially, the debt has become like equity: its value will depend directly on your estimate for the enterprise value. To value debt in these situations, apply an integrated-scenario approach. Exhibit 16.3 presents a simple two-scenario example for a company with ­significant debt. In scenario A, the company’s management can implement improvements in operating margin, inventory turns, and so on. In scenario B, changes are unsuccessful, and performance remains at its current level. For each scenario, estimate the enterprise value conditional on your fi- nancial forecasts.14 Next, deduct the full value of the debt and other nonequity claims from enterprise value. The full value is not the market value, but rather the value of debt if the company were default free.15 If the full value of debt is greater than enterprise value, set the equity value to zero. To complete the valuation, weight each scenario’s resulting equity value by its probability of occurrence. For the company in Exhibit 16.3, scenario A leads to an equity valuation of $300 million, whereas the equity value in scenario B is zero. If the probability of each scenario is 50 percent, the value of equity is $150 million. The scenario valuation approach treats equity like a call option on enter- prise value. A more comprehensive model would estimate the entire distri- bution of potential enterprise values and use an option-pricing model, such as the Black-Scholes model, to value equity.16 Using an option-pricing model 14 All nonequity claims need to be included in the scenario approach for distressed companies. The order in which nonequity claims are paid upon liquidation will make a difference for the value of each nonequity claim but not for the equity value. 15 If the coupon rate does not equal the yield on comparable bonds, the value of debt will not equal the book value, even if the debt is default free. 16 Chapter 39 describes option-pricing models. 346  Moving from Enterprise Value to Value per Share rather than scenario analysis to value equity, however, has practical draw- backs. First, to model the distribution of enterprise values, you must forecast the expected change and volatility for each source of uncertainty, such as rev- enue growth and gross margin. This too easily becomes a mechanical exercise that replaces a thoughtful analysis of the underlying economics of potential scenarios. Second, most options models treat each source of uncertainty as independent of the others. This can lead to outcomes that are economically unrealistic. For these reasons, we believe a thoughtful scenario analysis will lead to a better-informed and more accurate valuation than an advanced op- tions model will. Valuing Debt Equivalents Debt equivalents have the characteristics of debt but are not formal loan con- tracts or traded securities. They include operating provisions such as plant decommissioning, nonoperating provisions such as restructuring charges, op- erating leases, and contingent liabilities such as pending lawsuits. We discuss the most common debt equivalents next. Provisions Certain provisions other than retirement-related liabilities must be deducted as debt equivalents. We distinguish four types of provisions (as introduced in Chapter 11 and discussed in detail in Chapter 21) and value them as follows: 1. Ongoing operating provisions (such as for warranties and product re- turns) are already accounted for in the free cash flows and therefore should not be deducted from enterprise value. EXHIBIT 16.3  Valuation of Equity Using Scenario Analysis $ million Enterprise value Face value of debt Equity value1 Probability of occurrence Weighted equity value Scenario A New owner successfully implements value improvements. 1,500 1,200 300 50% 150 Scenario B Company maintains current performance. 900 1,200 – 50% – Equity value: 150 1Equity value equals enterprise value less the face value of debt, or zero, whichever is greater.