Some Evidence on Financial Distress Costs and Their Effect on Cash Flows

21 Pages Posted: 24 Oct 2006

See all articles by Ignacio Velez-Pareja

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Patricia Rojas

University of the Andes (Colombia)

Date Written: October 29, 2006


In this work we explore the effect of book value leverage upon some financial indexes, such as real growth, payment terms from suppliers and gross and operating margins. We explore if there is statistical evidence on the influence of the book value leverage level in the financial distress or bankruptcy costs that appear as measured by the worsening of those indexes. Four dependent variables were explored: gross margin, operating margin, real growth in sales and payment terms from suppliers. In order to estimate the financial distress and bankruptcy costs associated with each dependent variable, logarithmic and semi-logarithmic models were constructed using data panel. We used a balanced sample composed by 644 firms from the commercial Colombian industry, provided by the Superintendence of Societies of Colombia. We also examined an unbalanced sample of 683 firms with Ordinary Least Squares (OLS) analysis. We found that there exists a relationship between book value leverage perceived by the market and gross margin. This allows us to explore the possibility to introduce the financial distress costs in the cash flows. The aim of the study is to explore a model that allows the analyst to include this effect in the forecasted financial statements. When this effect is included in the financial statements the free cash flows will be affected and hence the interaction of cash flows, cost of capital (weighted average cost of capital) and firm value calculated with the cash flows will eventually allow determining an optimal capital structure.

Keywords: Cash flows, forecasted financial statements, cost of capital, bankruptcy costs, financial distress costs

JEL Classification: D61, G12, G31, G33, H43

Suggested Citation

Velez-Pareja, Ignacio and Rojas, Patricia, Some Evidence on Financial Distress Costs and Their Effect on Cash Flows (October 29, 2006). Available at SSRN: or

Ignacio Velez-Pareja (Contact Author)

Grupo Consultor CAV Capital Advisory & Valuation ( email )

Ave Miramar # 18-93 Apt 6A
+573112333074 (Phone)


Patricia Rojas

University of the Andes (Colombia) ( email )

Carrera Primera # 18A-12
Bogota, DC D.C. 110311

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