Professor, within the framework of Trade-Off Theory, we know that bankruptcy costs reduce the tax benefits of debt. However, indirect distress costs, such as loss of reputation, customer churn, difficulty in retaining key employees, or deterioration in supplier and lender relationships, are difficult to quantify precisely. How can we realistically incorporate these costs into firm valuation models without the risk of overestimating or underestimating the firm's value? Are there any reliable empirical approaches or relevant case studies we can look at to better estimate them?
Dear Francesco,
It depends on the case. A good approach is to look at companies in the same industry that have had distress in the past and see how much they lost. There are more sophisticated ways using derivatives (CDSs, options). The complex problem is to separate the probability of distress and the costs given distress (indirect and direct); however, we often just need the expected loss due to default, which is available in bond prices, which use the analysis of credit rating agencies.
It depends on the case. A good approach is to look at companies in the same industry that have had distress in the past and see how much they lost. There are more sophisticated ways using derivatives (CDSs, options). The complex problem is to separate the probability of distress and the costs given distress (indirect and direct); however, we often just need the expected loss due to default, which is available in bond prices, which use the analysis of credit rating agencies.