The Cost of Financial Distress and the Timing of Default
50 Pages Posted: 4 Feb 2009 Last revised: 26 May 2009
Date Written: May 12, 2009
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--economic shocks--before becoming financially distressed. We show that if estimates of ex-ante financial distress costs are not filtered from the effects of future economic shocks, they are significantly biased upward, as far as an order of magnitude. Filtered from economic shocks, pure ex-ante distress costs average less than 1% of current firm value. We also estimate sensitivities of ex-ante distress costs to leverage that are generally far too small to offset the expected tax benefits. Extending our analysis to the cross section and time series, we confirm that ex-ante distress costs are highest: i) when the risk premium in debt markets is high, and ii) among firms with high systematic risk. Overall, our results suggest that most firms use debt too conservatively, but we characterize conditions under which they do not.
Keywords: financial distress costs, default probabilities
JEL Classification: G32, G33
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
What Do We Know About Capital Structure? Some Evidence from International Data
By Raghuram G. Rajan and Luigi Zingales
-
The Theory and Practice of Corporate Finance: Evidence from the Field
By John R. Graham and Campbell R. Harvey
-
The Theory and Practice of Corporate Finance: The Data
By John R. Graham and Campbell R. Harvey
-
Market Timing and Capital Structure
By Malcolm P. Baker and Jeffrey Wurgler
-
Market Timing and Capital Structure
By Malcolm P. Baker and Jeffrey Wurgler
-
Testing Tradeoff and Pecking Order Predictions About Dividends and Debt
By Eugene F. Fama and Kenneth R. French
-
Testing Static Trade-Off Against Pecking Order Models of Capital Structure
-
Optimal Capital Structure Under Corporate and Personal Taxation
By Harry Deangelo and Ronald W. Masulis