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We argue that firms in financial distress face real costs associated with financial restructuring, in addition to the agency costs identified elsewhere in the literature. Distress costs arise from the presence of debt in the firms financial structure. Because firms facing uncertain demand will act to minimize expected distress costs even when not near the point of defaulting on debts, the prospect of facing distress costs has implications for the optimization problem of every firm. Our model shows that distress costs have a nonlinear effect on the value function of the firm. This effect may make the firm risk averse or risk seeking, depending on the magnitude of expected distress costs, with very different implications for its output decisions. Our results bridge a gap between the emphasis of economists on risk aversion induced by financial distress and the view of legal scholars that financial distress induces risk-seeking behavior.

Debt Matters: The Firms Optimization Problem With Financial Distress