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The Risk-Adjusted Cost of Financial Distress

44 Pages Posted: 29 Sep 2005  

Heitor Almeida

University of Illinois at Urbana-Champaign; National Bureau of Economic Research (NBER)

Thomas Philippon

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

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Abstract

We argue that risk premia affect the valuation of financial distress costs because these costs are more likely to be incurred in bad times. We compute the NPV of distress costs using risk-adjusted default probabilities derived from corporate bond spreads. Because credit spreads are large, the magnitude of the risk adjustment is substantial. For a firm whose bonds are rated BBB, our benchmark calculations show that the risk-adjusted NPV of distress is 4.5% of pre-distress firm value. In contrast, a valuation of distress costs that ignores risk premia produces an NPV of distress of 1.4%. The risk adjustment also increases the marginal effect of leverage on distress costs. We show that risk-adjusted, marginal distress costs can be of similar magnitude as the marginal tax benefits of debt derived by Graham (2000). Thus, distress risk premia can help explain why firms appear rather conservative in their use of debt.

Keywords: Bankrupcty, corporate valuation, capital structure, default risk, yield spreads, debt conservatism

JEL Classification: G31

Suggested Citation

Almeida, Heitor and Philippon, Thomas, The Risk-Adjusted Cost of Financial Distress. 8th Annual Texas Finance Festival. Available at SSRN: https://ssrn.com/abstract=811586

Heitor Almeida (Contact Author)

University of Illinois at Urbana-Champaign ( email )

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HOME PAGE: http://www.business.illinois.edu/FacultyProfile/faculty_profile.aspx?ID=11357

National Bureau of Economic Research (NBER)

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Thomas Philippon

New York University (NYU) - Department of Finance ( email )

Stern School of Business
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New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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