Costs of Financial Distress: The German Evidence

Abstract

The trade off theory of capital structure states that firms choose their capital structure by comparing benefits against costs of using debt. Benefits of debt usually comprise tax savings and the avoidance of agency costs of equity. Financial researchers agree that a major part of the costs or disadvantages of using debt comes in the form of “bankruptcy costs” or “costs of financial distress” (cfd). 1 However, there is disagreement about whether ex ante (expected) cfd are big enough to account for empirically observable capital structures. Almeida/Philippon (2007) argue that the systematic risk of cfd requires it to be discounted with a discount rate that is lower than the riskless rate. The resulting increase in ex ante cfd would explain empirical capital structure choices solely by cfd. 2 In this paper we aim to measure these costs empirically for a sample of German industrial firms. We concentrate on the ex post indirect cfd that materialize when bankruptcy or a financial crisis occurs. The notion “direct” costs refers to all bankruptcy related payments to lawyers, courts etc., whereas all other losses in value (e. g. due to customers’, suppliers’ and competitors’ reactions) are labelled as “indirect” cfd. Evidence on indirect cfd in Germany is not existent: to our knowledge there is no study that tries to estimate ex post indirect cfd. Nevertheless