The Risk-Adjusted Cost of Financial Distress




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    • Almeida and Philippon are at the Stern School of Business, New York University and the National Bureau of Economic Research. We wish to thank an anonymous referee for insightful comments and suggestions. We also thank Viral Acharya, Ed Altman, Yakov Amihud, Long Chen, Pierre Collin-Dufresne, Joost Driessen, Espen Eckbo, Marty Gruber, Jing-Zhi Huang, Tim Johnson, Augustin Landier, Francis Longstaff, Pascal Maenhout, Lasse Pedersen, Matt Richardson, Chip Ryan, Tony Saunders, Ken Singleton, Rob Stambaugh, Jos Van Bommel, Ivo Welch, and seminar participants at the University of Chicago, MIT, Wharton, Ohio State University, London Business School, Oxford Said Business School, USC, New York University, the University of Illinois, HEC-Paris, HEC-Lausanne, Rutgers University, PUC-Rio, the 2006 WFA meetings, and the 2006 Texas Finance Festival for valuable comments and suggestions. We also thank Ed Altman and Joost Driessen for providing data. All remaining errors are our own.


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.