The Risk-Adjusted Cost of Financial Distress
by Heitor Almeida of New York University and NBER, and
Abstract: Financial distress is more likely to happen in bad times. The present value of distress costs therefore depends on risk premia. We estimate this value using risk-adjusted default probabilities derived from corporate bond spreads. For a BBB-rated firm, our benchmark calculations show that the NPV of distress is 4.5% of predistress value. In contrast, a valuation that ignores risk premia generates an NPV of 1.4%.We show that marginal distress costs can be as large as the marginal tax benefits of debt derived by Graham (2000). Thus, distress risk premia can help explain why firms appear to use debt conservatively.
Keywords: Financial distress, corporate valuation, capital structure, default risk, credit spreads, debt conservatism.
Published in: Journal of Finance, Vol. 62, No. 6, (December 2007), pp. 2557-2586.
Previously titled: How Large is the NPV of Financial Distress Costs?