How Large are Predefault Costs of Financial Distress? Estimates from a Dynamic Model

Redouane Elkamhi (), Daniel Kim () and Marco Salerno ()
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Redouane Elkamhi: Rotman School of Management, University of Toronto, Toronto, Ontario M5S 3E6, Canada
Daniel Kim: University of Waterloo, Waterloo, Ontario N2L 3G1, Canada
Marco Salerno: Total Portfolio at Healthcare of Ontario Pension Plan Trust Fund in Toronto, Toronto, Ontario M9A 5G0, Canada

Management Science, 2024, vol. 70, issue 11, 7373-7396

Abstract: We estimate the costs of financial distress prior to default (predefault costs) separately from the loss incurred at default (the loss given default) using a dynamic tradeoff model of capital structure. We show that predefault costs account for a large fraction of total distress costs, approximately 64.1%. At the same time, they vary across industries ranging from 32.1% to 75%. We demonstrate that the expected predefault costs of financial distress vary significantly across industries with a range between 3.2% and 8.3% and are higher for small firms relative to larger ones.

Keywords: dynamic capital structure; financial distress; structural estimation (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:70:y:2024:i:11:p:7373-7396

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