Distance to Default and Misspecification of Corporate Economic Value Added

Abstract

The objective of this paper is to offer a mathematical formulation of economic value added (EVA) that incorporates distance-to-default (DD) and thus a default-free capital structure. The latter is extended via the weighted average cost of capital (WACC) to introduce a default-free EVA. The data include the nonfinancial firms listed in the DJIA30 and NASDAQ100 covering the period 1992Q2–2023Q3. The results of standard specification tests and the GMM estimator show that (a) DD causes an increase in WACC and thus, EVA decreases; (b) the interest coverage ratio can be used effectively to compensate for default risk, thus adjusting the default-free EVA positively; (c) both EVA and default-free EVA can effectively be managed via common determinants, namely, net working capital ratio, total liabilities to EBITDA, sales growth rate, debt–equity ratio, and earnings per share; (d) the positive impact of the inflation rate on both EVA and default-free EVA justifies the use of default-free EVA as a metric for equity risk premium; and (e) the robustness of the results via stochastic geometric Brownian motion shows that the determinants of default-free EVA are stable. This paper contributes to related studies by incorporating credit risk via the DD into default-free EVA.