NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Risk-Adjusted Cost of Financial Distress

Heitor Almeida, Thomas Philippon

NBER Working Paper No. 11685
Issued in October 2005
NBER Program(s):   CF

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.

download in pdf format
   (664 K)

email paper

This paper is available as PDF (664 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Published: Heitor Almeida and Thomas Philippon "The Risk-Adjusted Cost of Financial Distress" The Journal of Finance, Volume 62: Issue 6 (2007)

Users who downloaded this paper also downloaded these:
Andrade and Kaplan w6145 How Costly is Financial (not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed
Jaffee and Shleifer w2558 Costs Of Financial Distress, Delayed Calls Of Convertible Bonds, And The Role Of Investment Banks
Philippon and Schnabl w14929 Efficient Recapitalization
Hoshi, Kashyap, and Scharfstein w3435 The Role of Banks in Reducing the Costs of Financial Distress in Japan
Faulkender and Petersen w9930 Does the Source of Capital Affect Capital Structure?
 
Publications
Activities
Meetings
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us