Approximation and quantative analysis of costs of financial distress

Abstract

This paper deals with the effects of cost of financial distress (COFD) on corporate debt leverage and, as a result, on firm’s total value. A thorough review of existing relevant investigations on evaluating and approximating COFD is held further. We conclude that both, direct and indirect COFD, have significant value for the going bottom-up firms (3-4,5% of pre-distressed value for direct costs and 8-10% - for indirect costs). The results for direct COFD seem to be stable over time (from earlier studies to present days) in various sectors of economy. On the contrary, indirect costs appear to be a source of controversy, since they are hardly observable in practice. Previously made cross-sectional analysis and empirical tests could probably lit the light on the problem of indirect COFD that is why this kind of studies are included in the review. The key factor for cross-sectional analysis is to choose appropriate proxies for potential bankruptcy prediction. Our review considers such determinants as firm’s profitability, volatility of profits, investment opportunities and size to influence the probability of potential bankruptcy. Moreover provided evidence show that firms with high R&D expenses suffer more in case of financial distress. Finally, we find that integral scores of bankruptcy (Altman’s Z-score and Ohlson’s O-score) appear to be the most common predictors of bankruptcy and can be employed as confident proxy for evaluating the probability of financial distress.