How Does Bankruptcy Risk Affect Stock Values?

Abstract

<p class="rmnorm" style="text-align: justify; line-height: normal; margin: 0in 0.6in 0pt 0.5in; tab-stops: .5in; mso-hyphenate: auto;"><span style="letter-spacing: 0pt; font-size: 10pt; mso-bidi-font-style: italic;"><span style="font-family: Times New Roman;">Research in corporate restructuring argues that the risk of bankruptcy reduces firm value by the present value of both the direct and indirect costs of bankruptcy.<span style="mso-spacerun: yes;">  </span>Additionally, the potential for bankruptcy affects both the investment horizon of investors and the discount rate implicit in equity values.<span style="mso-spacerun: yes;">  </span>This paper empirically examines the effect of cross-sectional differences in the probability of bankruptcy on the determinants of firm value.<span style="mso-spacerun: yes;">  </span>We estimate bankruptcy probabilities for an extensive sample of more than 38,000 firm-year observations over a twelve-year period.<span style="mso-spacerun: yes;">  </span>Using a valuation model that employs both book value and earnings, we provide empirical evidence that earnings multiples decrease as the estimated probability of bankruptcy increases.<span style="mso-spacerun: yes;">  </span>These results imply that investors and analysts rely less on current earnings and more on book value (which proxies for the firm’s liquidation value) as a firm’s probability of bankruptcy increases. </span></span></p>