The risk-adjusted costs of financial distress: a comment

Abstract

Almeida and Philippon (2007) argue that the present value of the costs of financial distress is considerably larger than previously estimated through failure to recognize that the relevant probabilities to use in this assessment are the risk-adjusted probabilities rather than the historical probabilities. However, Almeida and Philippon have still underestimated the present value of the costs of financial distress through failure to recognize that the costs are expected to grow over time, and correction for this more than doubles their present value. Accordingly, the present value of the tax benefits of debt net of the financial distress costs is now clearly negative rather than marginally positive.

Notes

¹The inflation data are drawn from the Consumer Price Index for all Urban Consumers: All items shown at http://research. stlouisfed.org/fred2/data/CPIAUCNS.txt

²It might be argued that g could be zero or negative for firms close to default. However, the analysis in Almeida and Philippon is clearly for typical firms and therefore the analysis in this article is conducted on the same basis. The estimate of g is consistent with this.

³Doubling the ‘benchmark’ financial distress costs shown in Almeida and Philippon (2007, Table IV) and deducting them from the tax benefits shown in their Table VI, Panel A, yields net benefits that are negative at all leverage levels.