Thethirdstepistoevaluatetheeffectofthegivenlevelof
debt on the default risk of the firm and on expected
bankruptcy costs. This requires the estimation of the
probabilityofdefaultwiththeadditionaldebtandthedirect
and indirectcost ofbankruptcy. Ifπa istheprobability of
defaultaftertheadditionaldebtandBCisthepresentvalueof
thebankruptcycost,thepresentvalueofexpectedbankruptcy
cost can be estimated.
Wecanusetheapproachesdescribedintheprecedingsection
toarriveatanestimateoftheprobabilityofbankruptcy.We
canalsoconsiderthedifferencebetweenthevalueofafirmas
a going concern and thedistress salevalue asthe cost of
bankruptcy.Thus,ifthepresentvalueofexpectedcashflows
is$5billion—thegoingconcernvalue—andthedistresssale
proceedsareexpectedtobeonly 25 percentofthebookvalue
of $4 billion, the bankruptcy cost is $4 billion.
Again, withdistressed firms,thepresentvalue ofexpected
bankruptcy costs is likely to be a large number. The
combinationoflowtaxbenefitsandlargebankruptcycostsis
likely to reduce firm value.
Almeida and Philippon (2005) suggest a variation of the
adjustedpresentvaluemodel,arguingthattheconventional
measureofdistresscostsunderstatestheirmagnitudebecause
itdoesnotfactorin therealitythatdistresscostsareoften
systematic (market and economy driven).