The cost and timing of financial distress

Authors: Elkamhi, Redouane; Ericsson, Jan; Parsons, Christopher A.

Abstract:

Assessments of the trade-off theory have typically compared the present value of tax benefits to the present value of bankruptcy costs. We verify that this comparison overwhelmingly favors tax benefits, suggesting that firms are under-leveraged. However, when we allow firms to experience even modest (e.g., 1-2% annualized) financial distress costs prior to bankruptcy, the cumulative present value of such costs can easily offset the tax benefits. © 2012 Elsevier B.V. All rights reserved.

Journal of Financial Economics, 2012