The Cost of Financial Distress and the Timing of Default
University of Toronto - Rotman School of Management
Christopher A. Parsons
University of California, San Diego (UCSD) - Rady School of Management
McGill University; Swedish Institute for Financial Research (SIFR)
May 12, 2009
EFA 2009 Bergen Meetings Paper
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.
Number of Pages in PDF File: 50
Keywords: financial distress costs, default probabilities
JEL Classification: G32, G33
Date posted: February 4, 2009 ; Last revised: May 26, 2009
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