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A Market-Based Study of the Cost of DefaultSergei A. DavydenkoUniversity of Toronto - Finance Area Ilya A. StrebulaevStanford University - Graduate School of Business; National Bureau of Economic Research Xiaofei ZhaoUniversity of Toronto - Rotman School of Management March 2012 AFA 2012 Chicago Meetings Paper EFA 2011 Stockholm Meetings Paper Rock Center for Corporate Governance at Stanford University Working Paper No. 124 Abstract: Although the cost of financial distress is a central issue in capital structure and credit risk studies, reliable estimates of its size are difficult to come by. This paper proposes a novel method of extracting the cost of default from the change in the market value of a firm's assets upon default. Using a large sample of firms with observed prices of debt and equity that defaulted over 14 years, we estimate the cost of default for an average defaulting firm to be 21.7% of the market value of assets. The costs vary from 14.7% for bond renegotiations to 30.5% for bankruptcies, and are substantially higher for investment-grade firms (28.8%) than for highly-levered bond issuers (20.2%), which extant estimates are based on exclusively.
Number of Pages in PDF File: 56 Keywords: Default, Bankruptcy, Renegotiation, Costs of financial distress, Structural models, Credit risk JEL Classification: G21, G30, G33 working papers seriesDate posted: March 19, 2010 ; Last revised: August 22, 2012Suggested CitationContact Information
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