The Relationship between Expected Returns and Financial Distress Risk. Implication for Corporate Valuation

Sammanfattning: Using portfolio and regression analysis, this study examines the expected returns of European companies for the period 2000-2011 with respect to financial distress risk in order to provide practical implications for corporate valuation. The relationship between realized returns and financial distress risk is found to be negative, in line with the financial distress risk anomaly acknowledged in the existing literature. Based on the empirical evidence that financial distress risk contains systematic components, this anomaly contradicts the fundamental risk-return relationship. On the contrary, the association between the alternative proxy for expected returns - implied cost of equity - and financial distress risk is found to be positive, meaning that investors account for financial distress risk in their ex ante expectations. Implied cost of equity is obtained as an internal rate of return from current market prices and analysts' consensus earnings forecasts. Finally, comparing the implied cost of equity and the CAPM based cost of equity it is recommended to use a premium over CAPM based cost of equity of 0.6% to 1.35% for companies with high risk of financial distress.