THE SURVIVAL ISSUE

Implicit in the use of a terminal value in discounted cash flow valuation is the assumption that the value of a firm comes from it being a going concern with a perpetual life. For many risky firms, there is the very real possibility that they might not be in existence in 5 or 10 years, with volatile earnings and shifting technology. Should the valuation reflect this chance of failure, and, if so, how can the likelihood that a firm will not survive be built into a valuation?

Life Cycle and Firm Survival

There is a link between where a firm is in the life cycle and survival. Young firms with negative earnings and cash flows can run into serious cash flow problems and end up being acquired by firms with more resources at bargain basement prices. Why are young firms more exposed to this problem? The negative cash flows from operations, when combined with significant reinvestment needs, can result in a rapid depletion of cash reserves. When financial markets are accessible and additional equity (or debt) can be raised at will, raising more funds to meet these funding needs is not a problem. However, when stock prices drop and access to markets becomes more limited, these firms can be in trouble.