The risk of bankruptcy is real. This may be truer for some companies over other companies – those with higher debt levels are considered riskier than those with less debt. Nevertheless, how do you account for the risk of bankruptcy? How do you account for this additional risk?
The risk of bankruptcy can be featured in your DCF model in two ways.
- Higher WACC: The most used method, although not the best method, is to feature the risk of bankruptcy by using a higher WACC.
- Probability of bankruptcy: Another way that the probability of bankruptcy is incorporated into a DCF model is to estimate the value of the firm without any risk of bankruptcy and then multiply the value with (1- the probability of bankruptcy).