The Costs of Financial Distress ; Evidence from Credit Default Swaps

This study utilizes a newly available data, Credit Default Swap (CDS) spreads, to revisit the calculation of the NPV of financial distress costs. The results show that the cost of financial distress estimated here is on average more than what previous studies have estimated. This new measure of the cost of financial distress is further verified by analyzing the variables often attributed to the financial distress. The risk-adjusted probability of default using Almeida and Philippon (2007) is 0.23% where the conditional probability of default using the CDS spreads is 1.42%. This large difference translates to a much larger average cost of financial distress of 30% compared to the risk-adjusted cost of financial distress of 7.42%, using CDS premiums and credit spreads, respectively. Introduction Trade-off theory of capital structure state that the mix of capital in a firm is determined by the trade-off between the benefits of debt and the costs of debt. One of the major costs of debt is the cost of financial distress which can be direct or indirect. Consequently, there were some attempts to estimate the bankruptcy or financial distress costs (Warner (1977), Altman (1984), Weiss (1990), Opler and Titman (1994), Andrade and Kaplan (1998), Almeida and Philippon (2007)) and the consensus is that the direct costs of financial distress such as administrative and legal costs associated with the bankruptcy process are relatively small. For example Warner (1977) and Weiss (1990) estimate the direct cost of distress is 3%-5% of the value of the distress firms. On the other hand, the indirect costs of distress, such as loss of market share (Opler and Titman (1994)) and inefficient sale of assets (Shleifer and Vishny(1992)) can be very significant. For example Altman (1984) estimate these costs to be 11%-17% firm value three years before the bankruptcy. Andrade and Kaplan (1998) show similar results to Altman (1984) and estimate the cost of financial distress to be 10%-23% of pre-distress firm value for a sample of firms involved 1 Mohsen Mollagholamali is doctoral candidate at Oklahoma State University and can be reached at mohsen.mollagholamali@okstate.edu or (405) 762-3589 2 in high leverage buyouts. However, estimating the indirect costs of financial distress is a challenging task because these are not as easy as direct costs to quantify. Almeida and Philippon (2007) develop a framework to quantify the Net Present Value (NPV) of financial distress costs using the risk-neutral probabilities of default rather than historical default rates. They find that the distress costs derived from the historical default rates significantly underestimate the average value of distress costs. In other words, Almeida and Philippon (2007)’s measure could explain, at least partially, the conservative leverage ratios of the US firms despite the existence of sizeable tax benefits of debt as suggested by Graham (2000). There is an extensive literature (Elton et al. (2001), Chen et al. (2007), Huang and Huang (2003), Eom et al. (2004), Huang and Huang (2012)) about the role of default risk in explaining yield spreads such as those used in Almeida and Philippon (2007). These papers point out a need for a better measure of default likelihood for any study that involves this measure. Recent literature (Longstaff, Mithal, and Neis (2005), Blanco et al. (2005), Ericsson et al. (2009)) has provided a new and a “cleaner” measure of default: Credit Default Swap (CDS) premium. Single name credit default swap is the most popular credit derivative and it serves as an insurance against worsening of creditworthiness of a bond issuer. These contracts enable firms to exchange their credit risk and have become an essential tool in credit risk management. Furthermore, as far as the speed with which new information is impounded into prices is concerned, Blanco et al. (2005) find that CDS market leads bond market. They argue that price discovery process occurs in CDS market and that CDS premiums are superior to credit spreads in reflecting new information. In other words, CDS spreads adjust to credit risk changes more quickly and accurately, which makes CDS market the best place for trading credit risk.