The Risk-Adjusted Cost of Financial Distress

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 risk-adjusted 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 risk-adjustment 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.