The Costs of Financial Distress Across Industries

Abstract

I estimate the market's opinion of ex-ante costs of financial distress (CFD) from a structurally motivated model of the industry, using a panel dataset of monthly market values of debt and equity for 269 firms in 23 industries between 1994 and 2004. CFD are identified from market values and betas of a company's debt and equity. The market expects costs of financial distress of 5% of firm value for observed leverage ratios. In bankruptcy, distress costs can rise as high as 31%. Across industries, CFD are driven primarily by the potential for debt overhang problems and distressed asset fire-sales. There is considerable empirical support for the hypothesis that firms choose a leverage ratio based on the trade-off between tax benefits and CFD. The results do not confirm the under-leverage puzzle for firms with publicly traded debt.