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

See all articles by Redouane Elkamhi

Redouane Elkamhi

University of Toronto - Rotman School of Management

Marco Salerno

University of Toronto - Rotman School of Management

Date Written: February 27, 2020

Abstract

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

Elkamhi, Redouane and Salerno, Marco, How large are Pre-Default Costs of Financial Distress? Estimates from a Dynamic Model (February 27, 2020). Available at SSRN: https://ssrn.com/abstract=3553063 or http://dx.doi.org/10.2139/ssrn.3553063

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Marco Salerno (Contact Author)

University of Toronto - Rotman School of Management ( email )

Toronto, Ontario M5S 3G8
Canada

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