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

Author

Listed:
  • 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)

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.

Suggested Citation

  • Redouane Elkamhi & Daniel Kim & Marco Salerno, 2024. "How Large are Predefault Costs of Financial Distress? Estimates from a Dynamic Model," Management Science, INFORMS, vol. 70(11), pages 7373-7396, November.
    • Handle: RePEc:inm:ormnsc:v:70:y:2024:i:11:p:7373-7396
    DOI: 10.1287/mnsc.2023.4974
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