The Cost of Financial Distress and the Timing of Default

50 Pages Posted: 4 Feb 2009 Last revised: 26 May 2009

Redouane Elkamhi

University of Toronto - Rotman School of Management

Christopher A. Parsons

University of California, San Diego (UCSD) - Rady School of Management

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Date Written: May 12, 2009

Abstract

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.

Keywords: financial distress costs, default probabilities

JEL Classification: G32, G33

Suggested Citation

Elkamhi, Redouane and Parsons, Christopher A. and Ericsson, Jan, The Cost of Financial Distress and the Timing of Default (May 12, 2009). EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1337298 or http://dx.doi.org/10.2139/ssrn.1337298

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6
Canada

Christopher A. Parsons (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Mail Code 0502
La Jolla, CA 92093-0112
United States

Jan Ericsson

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

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