Coronavirus-triggered economic downturn could lead to many performing loans becoming distressed, especially for highly-leveraged companies. The extent of the downturn remains unclear given uncertainties of the trajectory of the pandemic and the unprecedented volatility in the financial markets. As such, the valuation of distressed credit requires approaches and considerations different from those used for performing loans.
The valuation of a performing debt instrument is typically fairly straightforward. It is normally based on the income approach, also referred to as a discounted cash flow analysis. This involves projecting the future cash flows and discounting them at an appropriate risk-adjusted discount rate. However, when a debt security becomes distressed, a traditional yield analysis may not be appropriate. In this article, we discuss some distressed debt valuation considerations in the context of valuations for financial reporting purposes.
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