A Market-Based Study of the Cost of Default
Sergei A. Davydenko
University of Toronto - Finance Area
Ilya A. Strebulaev
Stanford University - Graduate School of Business; National Bureau of Economic Research
University of Texas at Dallas - Jindal School of Management
AFA 2012 Chicago Meetings Paper
EFA 2011 Stockholm Meetings Paper
Rock Center for Corporate Governance at Stanford University Working Paper No. 124
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
Date posted: March 19, 2010 ; Last revised: August 22, 2012
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