A Market-Based Study of the Cost of Default
AFA 2012 Chicago Meetings Paper
EFA 2011 Stockholm Meetings Paper
Rock Center for Corporate Governance at Stanford University Working Paper No. 124
56 Pages Posted: 19 Mar 2010 Last revised: 22 Aug 2012
Date Written: March 2012
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.
Keywords: Default, Bankruptcy, Renegotiation, Costs of financial distress, Structural models, Credit risk
JEL Classification: G21, G30, G33
Suggested Citation: Suggested Citation
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