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Book/Printed Material The risk-adjusted cost of financial distress

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Title

  • The risk-adjusted cost of financial distress

Summary

  • "In this paper we argue that risk-adjustment matters for the valuation of financial distress costs, since financial distress is more likely to happen in bad times. Systematic distress risk implies that the risk-adjusted probability of financial distress is larger than the historical probability. Alternatively, the correct valuation of distress costs should use a discount rate that is lower than the risk free rate. We derive a formula for the valuation of distress costs, and propose two strategies to implement it. The first strategy uses corporate bond spreads to derive risk-adjusted probabilities of financial distress. The second strategy estimates the risk adjustment directly from historical data on distress probabilities, using several established asset pricing models. In both cases, we find that exposure to systematic risk increases the NPV of financial distress costs. In addition, the magnitude of the risk-adjustment can be very large, suggesting that a valuation of distress costs that ignores systematic risk significantly underestimates their true present value. Finally, we show that marginal distress costs computed using our new formula can be large enough to balance the marginal tax benefits of debt derived by Graham (2000), and we conclude that systematic distress risk can help explain why firms appear rather conservative in their use of debt"--National Bureau of Economic Research web site.

Names

  • Almeida, Heitor
  • Philippon, Thomas
  • National Bureau of Economic Research

Created / Published

  • Cambridge, MA : National Bureau of Economic Research, c2005.

Headings

  • -  Corporations--Finance--Mathematical models
  • -  Risk management

Notes

  • -  Title from PDF file as viewed on 11/18/2005.
  • -  Includes bibliographical references.
  • -  Also available in print.
  • -  Mode of access: World Wide Web.
  • -  System requirements: Adobe Acrobat Reader.

Call Number/Physical Location

  • HB1

Digital Id

Library of Congress Control Number

  • 2005620765

Access Advisory

  • Unrestricted online access

Online Format

  • image
  • pdf

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Cite This Item

Citations are generated automatically from bibliographic data as a convenience, and may not be complete or accurate.

Chicago citation style:

Almeida, Heitor, Thomas Philippon, and National Bureau Of Economic Research. The Risk-Adjusted Cost of Financial Distress. Cambridge, MA: National Bureau of Economic Research, 2005. Pdf. https://aj.sunback.homes/item/2005620765/.

APA citation style:

Almeida, H., Philippon, T. & National Bureau Of Economic Research. (2005) The Risk-Adjusted Cost of Financial Distress. Cambridge, MA: National Bureau of Economic Research. [Pdf] Retrieved from the Library of Congress, https://aj.sunback.homes/item/2005620765/.

MLA citation style:

Almeida, Heitor, Thomas Philippon, and National Bureau Of Economic Research. The Risk-Adjusted Cost of Financial Distress. Cambridge, MA: National Bureau of Economic Research, 2005. Pdf. Retrieved from the Library of Congress, <aj.sunback.homes/item/2005620765/>.