Estimating Risk-Adjusted Costs of Financial Distress (original) (raw)
Related papers
The Risk-Adjusted Cost of Financial Distress
The Journal of Finance, 2007
In this paper we argue that risk-adjustment matters for the valuation of financial distress costs, since financial distress is more likely to happen in bad times. Systematic distress risk implies that the riskadjusted probability of financial distress is larger than the historical probability. Alternatively, the correct valuation of distress costs should use a discount rate that is lower than the risk free rate. We derive a formula for the valuation of distress costs, and propose two strategies to implement it. The first strategy uses corporate bond spreads to derive risk-adjusted probabilities of financial distress. The second strategy estimates the risk adjustment directly from historical data on distress probabilities, using several established asset pricing models. In both cases, we find that exposure to systematic risk increases the NPV of financial distress costs. In addition, the magnitude of the riskadjustment can be very large, suggesting that a valuation of distress costs that ignores systematic risk significantly underestimates their true present value. Finally, we show that marginal distress costs computed using our new formula can be large enough to balance the marginal tax benefits of debt derived by Graham (2000), and we conclude that systematic distress risk can help explain why firms appear rather conservative in their use of debt.
The cost of financial distress and the timing of default
2010
Abstract: At any point in time, most firms are not in financial distress. This implies that they must suffer value losses unrelated to their leverage before becoming financially distressed. We first show that if estimates of ex-ante distress costs are not filtered of such non-debt related value declines, they are biased upward as far as an order of magnitude. Then, we develop a methodology for calculating" pure" ex ante distress costs, and apply this to a large panel of public firms.
Determinants of Financial Distress Costs
Financial Markets and Portfolio Management, 2005
This paper provides international evidence on financial distress costs. To achieve this aim, we have developed a model where financial distress costs are determined, on the one hand, by making use of a more accurate indicator of the probability of financial distress and, on the other, by a set of variables that, according to financial theory, explain the magnitude of the costs borne by a firm in the case of financial distress. Our results reveal the relevance of our improved indicator of the probability of financial distress, since it positively affects financial distress costs in all the countries analyzed. Furthermore, since our model controls for the probability of financial distress, we can test the trade-off between the benefits and costs of debt. This allows us to verify that the benefits debt outweigh the costs. Our results also indicate that distress costs are negatively related to liquid assets; hence, their benefits more than offset their opportunity costs.
The Journal of Finance, 2008
This paper explores the determinants of corporate failure and the pricing of financially distressed stocks using US data over the period 1963 to 2003. Firms with higher leverage, lower profitability, lower market capitalization, lower past stock returns, more volatile past stock returns, lower cash holdings, higher market-book ratios, and lower prices per share are more likely to file for bankruptcy, be delisted, or receive a D rating. When predicting failure at longer horizons, the most persistent firm characteristics, market capitalization, the market-book ratio, and equity volatility become relatively more significant. Our model captures much of the time variation in the aggregate failure rate. Since 1981, financially distressed stocks have delivered anomalously low returns. They have lower returns but much higher standard deviations, market betas, and loadings on value and small-cap risk factors than stocks with a low risk of failure. These patterns hold in all size quintiles but are particularly strong in smaller stocks. They are inconsistent with the conjecture that the value and size effects are compensation for the risk of financial distress.
A Market-Based Study of the Cost of Default
Review of Financial Studies, 2012
Although the cost of financial distress is a central issue in capital structure and credit risk studies, reliable estimates of its size are difficult to come by. This paper proposes a novel method of extracting the cost of default from the change in the market value of a firm's assets upon default. Using a large sample of firms with observed prices of debt and equity that defaulted over 14 years, we estimate the cost of default for an average defaulting firm to be 21.7% of the market value of assets. The costs vary from 14.7% for bond renegotiations to 30.5% for bankruptcies, and are substantially higher for investment-grade firms (28.8%) than for highly-levered bond issuers (20.2%), which extant estimates are based on exclusively.
This paper studies thirty-one highly leveraged transactions ~HLTs! that become financially, not economically, distressed. The net effect of the HLT and financial distress ~from pretransaction to distress resolution, market-or industry-adjusted! is to increase value slightly. This finding strongly suggests that, overall, the HLTs of the late 1980s created value. We present quantitative and qualitative estimates of the ~direct and indirect! costs of financial distress and their determinants. We estimate financial distress costs to be 10 to 20 percent of firm value. For a subset of firms that do not experience an adverse economic shock, financial distress costs are negligible.
Corporate Financial Distress and Bankruptcy
Corporate Financial Distress and Bankruptcy, 2005
The authors would like to acknowledge the useful comments of Professor Jan Bilderbeek from Twent University and also the financial assistance of Natural Science Foundation of China (NSFC). Data assistance from Xiongwei Wu, Xin Zhang, Yanchun Cao and Shenzhen GuoTai'An Information Technology (GTA) is also acknowledged.
The cost and timing of financial distress
2012
Assessments of the trade-off theory have typically compared the present value of tax benefits to the present value of bankruptcy costs. We verify that this comparison overwhelmingly favors tax benefits, suggesting that firms are under-leveraged. However, when we allow firms to experience even modest (eg, 1���2% annualized) financial distress costs prior to bankruptcy, the cumulative present value of such costs can easily offset the tax benefits.
2017
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