The risk-adjusted cost of financial distress

Heitor Almeida, Thomas Philippon

Research output: Contribution to journalArticle

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.

Original languageEnglish (US)
Pages (from-to)2557-2586
Number of pages30
JournalJournal of Finance
Volume62
Issue number6
DOIs
StatePublished - Dec 1 2007
Externally publishedYes

Fingerprint

Distress
Financial distress
Costs
Risk premia
Debt
Corporate bonds
Tax
Bond spreads
Present value
Default probability
Benchmark

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

Cite this

The risk-adjusted cost of financial distress. / Almeida, Heitor; Philippon, Thomas.

In: Journal of Finance, Vol. 62, No. 6, 01.12.2007, p. 2557-2586.

Research output: Contribution to journalArticle

Almeida, Heitor ; Philippon, Thomas. / The risk-adjusted cost of financial distress. In: Journal of Finance. 2007 ; Vol. 62, No. 6. pp. 2557-2586.
@article{b2e0d6b3864249818456637b78490d5f,
title = "The risk-adjusted cost of financial distress",
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.",
author = "Heitor Almeida and Thomas Philippon",
year = "2007",
month = "12",
day = "1",
doi = "10.1111/j.1540-6261.2007.01286.x",
language = "English (US)",
volume = "62",
pages = "2557--2586",
journal = "Journal of Finance",
issn = "0022-1082",
publisher = "Wiley-Blackwell",
number = "6",

}

TY - JOUR

T1 - The risk-adjusted cost of financial distress

AU - Almeida, Heitor

AU - Philippon, Thomas

PY - 2007/12/1

Y1 - 2007/12/1

N2 - 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.

AB - 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.

UR - http://www.scopus.com/inward/record.url?scp=36649034710&partnerID=8YFLogxK

UR - http://www.scopus.com/inward/citedby.url?scp=36649034710&partnerID=8YFLogxK

U2 - 10.1111/j.1540-6261.2007.01286.x

DO - 10.1111/j.1540-6261.2007.01286.x

M3 - Article

AN - SCOPUS:36649034710

VL - 62

SP - 2557

EP - 2586

JO - Journal of Finance

JF - Journal of Finance

SN - 0022-1082

IS - 6

ER -