The Cost of Financial Distress and the Timing of Default

At any point in time, most firms are not in financial distress. This implies that they must suffer value losses unrelated to their leverage before becoming financially distressed. We first show that if estimates of ex-ante distress costs are not filtered of such non-debt related value declines, they are biased upward as far as an order of magnitude. Then, we develop a methodology for calculating "pure" ex ante distress costs, and apply this to a large panel of public firms. In contrast to recent studies, our analysis suggests that expected losses at default are far too small to offset the tax benefits of leverage. If there is a balance, it is because firms incur substantial losses prior to defaulting, such as damaging relationships with customers or attracting predation