OVERVIEW

Up to this point, the concepts of firm value and capital structure have been discussed without worrying about how they are derived. The ever-present Boxco behaves like so much Silly Putty: its asset value box expands and then shrinks, and then the boxes on the other side (debt and equity) are stretched or chopped down to conform. This is a conceptually sound construct because, as a general proposition, capital structure must, in the long run, bear some relation to asset value. The dependence or causality is from asset value to capital structure, not vice versa.

In Chapter 3, this construct was used to depict the concept of financial distress and how it will often force a restructuring of the capital structure: the asset box shrinks, so the liability and equity boxes must be chopped down to conform (review Figure 3-8). As was discussed in Chapter 4, whether this restructuring is done through a voluntary agreement among the creditors or under the auspices of a bankruptcy proceeding, the basic notion of matching the capital structure to the asset value is the same. ^[1] But for this exercise to have practical relevance to the distressed debt investor, it must advance from concept to concrete. Bonds trade at prices. To assess whether a bond should be bought or sold at any given price requires the development of techniques to estimate the size of the asset box and, having derived that, decide if the size of the debt box implied by a...