Publications (3)0 Total impact
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Article: Estimating Risk-Adjusted Costs of Financial Distress
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ABSTRACT: The search for the optimal, or value-maximizing, capital structure involves weighing the expected benefits of higher leverage against the expected "costs of financial distress." These costs include not only the direct costs of reorganization, but less quantifiable effects of financial trouble such as damage to the firm's reputation, the loss of key employees and customers, and the loss of value from forgone investment opportunities. Copyright (c) 2008 Morgan Stanley.Journal of Applied Corporate Finance 01/2008; 20(4):105-109. -
Article: The Risk-Adjusted Cost of Financial Distress
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ABSTRACT: Financial distress is more likely to happen in bad times. The present value of distress costs therefore depends on risk premia. We estimate this value using risk-adjusted default probabilities derived from corporate bond spreads. For a BBB-rated firm, our benchmark calculations show that the NPV of distress is 4.5% of predistress value. In contrast, a valuation that ignores risk premia generates an NPV of 1.4%. We show that marginal distress costs can be as large as the marginal tax benefits of debt derived by Graham (2000) . Thus, distress risk premia can help explain why firms appear to use debt conservatively. Copyright 2007 by The American Finance Association.Journal of Finance. 02/2007; 62(6):2557-2586. -
Article: How should we discount the costs of financial distress?
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ABSTRACT: Practitioners and academics usually discount expected future costs of financial distress using a government bond yield, and sometimes using the firm's own cost of debt. We argue that this practice is wrong and that it underestimates the true present value of distress costs, because distress is more likely to happen when other assets perform poorly. Thus, the costs of financial distress must be discounted by less than the risk free rate. Equivalently, we argue that the risk adjusted probability of financial distress is significantly larger than the actual probability. We present two strategies to estimate the correct discount rate. First, we replicate the distress costs using a government bond and the firm's risky debt, and we derive the risk adjusted probability as a simple function of the corporate bond spread and the risk free rate. The second strategy is to estimate the risk adjustment directly from the historical time series of financial distress and some well established asset pricing models. We find that the probability of distress is indeed higher in bad times. The two methods give qualitatively similar results, but the first suggests a larger bias than the second. According to the replicating approach, the optimal bond rating is AA, while according to the second approach it is BBB. We conclude that our risk adjustment can explain why firms seem to be "debt-conservative".
