A Market-Based Study of the Costs of Default
by Sergei A. Davydenko of the University of Toronto,
Abstract: Although the cost of financial distress is a central issue in capital structure and credit risk studies, reliable empirical estimates of its size are difficult to come by. This paper proposes a novel method of estimating the total costs of default from market values of defaulting firms. It is based on the idea that the jump in the combined market value of debt and equity upon the announcement of default reflects the total cost of default as well as the degree to which it is a surprise for investors. Using a large sample of firms with observed market prices of bonds, bank debt, and equity at default, in the benchmark case we estimate the cost of default at 20.4% of the market value of assets. The costs vary from 12.8% for bond renegotiations to 28.8% for bankruptcies, and are substantially higher for investment-grade firms (28.1%) than for highly-levered firms (19.3%), which previous research focuses on.
Keywords: Default, Bankruptcy, Renegotiation, Costs of financial distress