How large are Pre-Default Costs of Financial Distress? Estimates from a Dynamic Model
75 Pages Posted: 6 Apr 2020 Last revised: 4 Jan 2021
Date Written: February 27, 2020
We estimate the costs of financial distress prior to default (pre-default costs) separately from the loss incurred at default (the loss given default) using a dynamic trade-off model of capital structure. We document that pre-default costs are on average equal to 6.5% of firm value per year. We show that pre-default costs account for a large fraction of total distress costs, approximately 68.5%. Last, we show that the expected pre-default costs of financial distress vary significantly across industries with a range between 3.75% and 8.75%, and are higher for firms with highly tangible assets.
Keywords: Dynamic Capital Structure, Financial Distress, Structural Estimation
JEL Classification: G30, G32, G33
Suggested Citation: Suggested Citation