The Costs of Financial Distress across Industries
by Arthur Korteweg of the University of Chicago
January 15, 2007
Abstract: In this paper I estimate the market's opinion of ex-ante costs of financial distress (CFD) from a structurally motivated model of the industry, using a panel dataset of monthly market values of debt and equity for 244 firms in 22 industries between 1994 and 2004. Costs of financial distress are identified from the market values and systematic risk of a company's debt and equity. The market expects costs of financial distress to be 0-11% of firm value for observed levels of leverage. In bankruptcy, the costs of distress can rise as high as 31%. Across industries, CFD are driven primarily by the potential for under-investment problems and distressed asset fire-sales, as measured by spending on research and development and the proportion of intangible assets in the firm. There is considerable empirical support for the hypothesis that firms choose a leverage ratio based on the trade-off between tax benefits and costs of financial distress. The results do not confirm the under-leverage puzzle for firms with publicly traded debt.