The Risk-Adjusted Cost of Financial Distress

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