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Debt Valuation
In the enterprise model of valuation, the firm's equity value is calculated by subtractingthe value of the firm's debt from the enterprise value. Debt valuation then becomes animportant component of a valuation of the firm's equity.A company's debt is valued by calculating the payoffs that debt holders can expect toreceive, taking into account the risk of default. The default risk is addressed byconsidering the probability of default and the amount that could be recovered in thatevent. For modeling purposes, one may assume that the cash flow from the recoveredamount is realized at the end of the year of default.Debt valuation may take one of the following two approaches:1.Discount the expected cash flow at the expected bond return; or 2.Discount the scheduled bond payments at the rating-adjusted yield-to-maturity.
Debt Valuation - Method 1
Discount the expected cash flow at the expected bond returnUnder this method, the value of the bond is the sum of the expected annual cash flowsdiscounted at the expected bond return:Value = the sum for each year 
t
of E(cash flow)
t
/ ( 1 + r 
debt
)
t
where E(cash flow)
t
= expected cash flow in year 
t
.For a one year bond: Value = E(cash flow) / [1 + E(r 
d
)]The expected bond return is the risk-adjusted discount rate, r 
debt
.The expected cash flow is the cash flow considering the probability of default:E(cash flow) = π ( 1 + C ) F + ( 1 - π ) λ F
whereπ = probability of no defaultλ = recovery rate in case of default, (percentage of face value)C = annual coupon rate of the bondF = face value of the bond
r 
debt
can be calculated using the CAPM:r 
debt
= r 
f 
+ β
debt
Π
S&P500
of 00

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