Estimating Risk-Adjusted Costs of Financial Distress

Abstract

The search for the optimal, or val ue-maximizing, capital structure involves weighing the expected benefits of higher leverage against the expected "costs of financial distress." These costs include not only the direct costs of reorganization, but less quantifiable effects of financial trouble such as damage to the firms reputation, the loss of key employees and customers, and the loss of value from forgone investment opportunities.

This article proposes a new method for valuing expected financial distress costs. While researchers have provided estimates of the costs associated with financial distress when it takes place, whether or when these costs will be incurred is, of course, unknown at the time the financing decision. As a result, the "correct" discount rate for valuing expected distress costs is difficult to derive. Instead of adjusting the discount rate to reflect historical default rate probabilities, the authors' method uses "risk-neutral" probabilities of encountering distress that allow for discounting at the risk-free rate. The risk-neutral probabilities of default are derived by incorporating the systematic risk premia implicit in corporate bond yield spreads.

This method results in a significant increase in estimates of financial distress costs. In a simple example presented by the authors, distress costs estimated at about 1.6% of firm value using the conventional method turn out to run about 5% after adjusting for the increased systematic risk associated with financial distress.