The Risk-Adjusted Cost of Financial Distress

Heitor Almeida · Thomas Philippon

65 citations0/0 files storedThe Journal of Finance

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Corporate Insolvency and Governance Corporate Finance and Governance Financial Distress and Bankruptcy Prediction

Abstract

ABSTRACT Financial distress is more likely to happen in bad times. The present value of distress costs therefore depends on risk premia. We estimate this value using risk‐adjusted default probabilities derived from corporate bond spreads. For a BBB‐rated firm, our benchmark calculations show that the NPV of distress is 4.5% of predistress value. In contrast, a valuation that ignores risk premia generates an NPV of 1.4%. We show that marginal distress costs can be as large as the marginal tax benefits of debt derived by Graham (2000) . Thus, distress risk premia can help explain why firms appear to use debt conservatively.

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References

1993Common risk factors in the returns on stocks and bonds 1977Determinants of corporate borrowing 1999By Force of Habit: A Consumption‐Based Explanation of Aggregate Stock Market Behavior 1989Business conditions and expected returns on stocks and bonds 1992Liquidation Values and Debt Capacity: A Market Equilibrium Approach 1994Corporate Debt Value, Bond Covenants, and Optimal Capital Structure 1999Modeling Term Structures of Defaultable Bonds 2001The Determinants of Credit Spread Changes

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