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.
|Date of creation:||Oct 2005|
|Date of revision:|
|Publication status:||published as Heitor Almeida and Thomas Philippon "The Risk-Adjusted Cost of Financial Distress" The Journal of Finance, Volume 62: Issue 6 (2007)|
|Contact details of provider:|| Postal: |
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Cremers, Martijn & Driessen, Joost & Maenhout, Pascal & Weinbaum, David, 2008.
"Individual stock-option prices and credit spreads,"
Journal of Banking & Finance,
Elsevier, vol. 32(12), pages 2706-2715, December.
- Carlos A. Molina, 2005. "Are Firms Underleveraged? An Examination of the Effect of Leverage on Default Probabilities," Journal of Finance, American Finance Association, vol. 60(3), pages 1427-1459, 06.
- Ofek, Eli, 1993. "Capital structure and firm response to poor performance: An empirical analysis," Journal of Financial Economics, Elsevier, vol. 34(1), pages 3-30, August.
- Gregor Andrade & Steven N. Kaplan, 1998.
"How Costly is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed,"
Journal of Finance,
American Finance Association, vol. 53(5), pages 1443-1493, October.
- Gregor Andrade & Steven N. Kaplan, 1997. "How Costly is Financial (not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed," NBER Working Papers 6145, National Bureau of Economic Research, Inc.
- Sheridan Titman & Sergey Tsyplakov, 2007.
"A Dynamic Model of Optimal Capital Structure,"
Review of Finance,
European Finance Association, vol. 11(3), pages 401-451.
- Paul Asquith & Robert Gertner & David Scharfstein, 1991.
"Anatomy of Financial Distress: An Examination of Junk-Bond Issuers,"
NBER Working Papers
3942, National Bureau of Economic Research, Inc.
- Asquith, Paul & Gertner, Robert & Scharfstein, David, 1994. "Anatomy of Financial Distress: An Examination of Junk-Bond Issuers," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 625-58, August.
- Opler, Tim C & Titman, Sheridan, 1994. " Financial Distress and Corporate Performance," Journal of Finance, American Finance Association, vol. 49(3), pages 1015-40, July.
- Long Chen & Pierre Collin-Dufresne & Robert S. Goldstein, 2009. "On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3367-3409, September.
- Steven A. Sharpe, 1993.
"Financial market imperfections, firm leverage and the cyclicality of employment,"
Finance and Economics Discussion Series
93-10, Board of Governors of the Federal Reserve System (U.S.).
- Sharpe, Steven A, 1994. "Financial Market Imperfections, Firm Leverage, and the Cyclicality of Employment," American Economic Review, American Economic Association, vol. 84(4), pages 1060-74, September.
- Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
- Warner, Jerold B, 1977. "Bankruptcy Costs: Some Evidence," Journal of Finance, American Finance Association, vol. 32(2), pages 337-47, May.
- Acharya, Viral V & Bharath, Sreedhar T & Srinivasan, Anand, 2003. "Understanding the Recovery Rates on Defaulted Securities," CEPR Discussion Papers 4098, C.E.P.R. Discussion Papers.
- Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
- Edward I. Altman & Brooks Brady & Andrea Resti & Andrea Sironi, 2005. "The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2203-2228, November.
- Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
- Christopher Hennessy & Toni Whited, 2004.
2004 Meeting Papers
592, Society for Economic Dynamics.
- Altman, Edward I, 1984. " A Further Empirical Investigation of the Bankruptcy Cost Question," Journal of Finance, American Finance Association, vol. 39(4), pages 1067-89, September.
- Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
- Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September.
- Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, vol. 56(1), pages 247-277, 02.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:11685. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.