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The Risk-Adjusted Cost of Financial Distress

  • HEITOR ALMEIDA
  • THOMAS PHILIPPON

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. Copyright 2007 by The American Finance Association.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 62 (2007)
Issue (Month): 6 (December)
Pages: 2557-2586

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Handle: RePEc:bla:jfinan:v:62:y:2007:i:6:p:2557-2586
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