Bankruptcy Costs Research Articles

Optimal restrictiveness of a financing covenant

This paper identifies the optimal restrictiveness of a financing covenant in a debt contract. We examine the decision of a debt-issuing company that has current operations as well as a future growth opportunity. The optimal financing covenant can substantially reduce the cost of debt financing, and generally allows the issuance of some debt for financing the expansion. Comparative static analysis indicates that the covenant is less likely to be included when growth opportunities, earnings volatility, earnings drift rate, interest rate and tax rate are higher; and when bankruptcy cost is lower. Also, the financing covenant is more likely when the leverage ratio is higher (bankruptcy risk is greater) but becomes less likely for very high leverage ratio (when the firm is in or close to financial distress). These results are generally consistent with existing empirical results in the literature.

Company Cost of Capital and Leverage: A Simplified Textbook Relationship Revisited

In this paper, we revisit a frequently employed simplification within the WACC approach that company cost of capital k_{V} is supposed to be invariant to the debt ratio and therefore equal to the unlevered cost k_{U}. Even though we know from Miles and Ezzell (1980) that k_{V} formally differs from k_{U}, treating both costs as equal strongly facilitates the practical firm valuation e.g. when companies strategically change their target debt ratios to a significantly different magnitude after a transaction. We provide both a theoretical model and an empirical analysis using 29 firms of the German stock market to quantify the economic significance between the company cost of a levered and an otherwise identical but unlevered firm. In particular, we can numerically support the usual simplification in the absence of default risk. In case that firms are default-risky, however, empirical findings indicate a clear difference between these costs equal to 1.88 percentage points on average even for moderate assumed bankruptcy costs which translates to a company mispricing of nearly 100%. As a result, the company cost of capital does practically not depend on the debt ratio if the firm is not subject to default risk or if bankruptcy costs are negligible. Otherwise, it does and a negligence of this relationship can cause significant mispricings.

Effect of labour income on the optimal bankruptcy problem

In this paper we deal with the optimal bankruptcy problem for agents who can optimally allocate their consumption rate, the amount of capital invested in the risky asset, as well as their leisure time. In our framework, the agents are endowed by an initial debt, and they are required to repay their debt continuously. Declaring bankruptcy, the debt repayment is exempted at the cost of a wealth shrinkage. We implement the duality method to solve the problem analytically and conduct a sensitivity analysis to the bankruptcy cost and benefit parameters. Introducing the flexible leisure/working rate, and therefore the labour income, into the bankruptcy model, we investigate its effect on the optimal strategies.

Mediating role of profitability relating financial leverage and stock returns

PurposeThis paper aims to highlight firms' profitability as an alternative channel by which changes in leverage could affect stock returns in an imperfect market setting. The author also analytically argues that the benefits of debt, if any, may accrue beyond the usual tax benefit channel.Design/methodology/approachThe author used multivariate regression models based on firms' characteristics and the models' changes along with a two-stage least-square (2SLS) type procedure to estimate the impact of leverage changes on stock returns. The author controls for the varying arbitrage risk that is measured by forecasted idiosyncratic volatility of stock prices and overcome simultaneous or endogenous determination by using inter-temporal non-synchronous variation in leverage and control variables.FindingsThe author finds that increase in leverage increase (decrease) stock returns for firms with the gross operating profitability higher (lower) than the cost of debt. The author also finds that the variation in arbitrage risk does not substitute for the primary effect of leverage changes on stock returns.Research limitations/implicationsThe author's findings provide tacit support to the recent literature attempting to resolve the empirically puzzling pattern of the negative relationship between profitability and leverage. The findings suggest inclusion of profitability as a crucial asset-pricing factor in the contemporary empirical models.Practical implicationsThe non-trivial role of profitability in determining the effect of leverage on firms' stock returns that may be useful to managers, credit analysts and policy makers to assess the impact of net profitability on any change in leverage and its ensuing consequences on firms' value.Originality/valueThe paper develops analytical insights into the marginal role of profitability in influencing the relationship between firms' financing decisions and firms' stock returns beyond the conventional mechanisms of tax benefits, bankruptcy costs and information asymmetry.

The income bond puzzle

The income bond puzzle

A dynamic program under Lévy processes for valuing corporate securities

Most structural models for valuing corporate securities assume a geometric Brownian motion to describe the value of a firm’s assets. However, this does not reflect market stylized features: the default is more often driven by unexpected information and sudden shocks, which are not captured by the Gaussian model assumption. To remedy this, we propose a dynamic program for valuing corporate securities under various Lévy processes. Specifically, we study two jump diffusions and a pure-jump process. Under these settings, we build and experiment with a flexible framework that accommodates the balance-sheet equality, arbitrary corporate debts, multiple seniority classes, tax benefits and bankruptcy costs. While our approach applies to several Lévy processes, we compute and detail the total value of equity, the total value of debt and the total value of the firm as well as the credit spreads of the debt by using Gaussian, double exponential and variance-gamma jump models.

Personal Bankruptcy Costs, Union Bargaining Power, and Capital Structure

Personal Bankruptcy Costs, Union Bargaining Power, and Capital Structure

Bankruptcy costs, idiosyncratic risk, and long-run growth

AbstractThis paper analyzes how idiosyncratic risk, measured by the variance of firm-level idiosyncratic shocks, affects long-run growth when bankruptcy costs are present. These costs are incurred by creditors during the bankruptcy procedure of failing firms. In an endogenous growth model with bankruptcy costs where firms privately observe the outcome of idiosyncratic shocks, an increase in idiosyncratic risk reduces long-run growth. This happens because, when bankruptcy costs are present, higher idiosyncratic risk enlarges the wedge between the rental rate of capital and its marginal product, thereby slowing down capital accumulation. This growth-reducing effect of idiosyncratic risk is stronger when bankruptcy costs are higher. Empirical support for these propositions is provided in a growth regression that exploits cross-country variations in the dispersion of firms’ real sales growth as a proxy for idiosyncratic risk along with recovery rates as a measure that proxies the inverse of bankruptcy costs.

Capitalization and profitability: applicability of capital theories in BRICS banking sector

The interrelationship between capitalization and profitability in banking sector of BRICS countries is studied with reference to existing five capital theories with the help of the ARDL and VECM/VAR models. These models are applied in the panel and individual settings on BRICS banking sector data from 2000 to 2020 to examine the presence of capital theories in the BRICS banking sectors. The study’s long-term empirical findings hold up the signalling and the bankruptcy cost hypothesis for the BRICS, Brazil, Russia, and India. Capitalization appears to be having a detrimental effect on profitability in China and South Africa, the agency argument is upheld. Profitability appears to have a considerable positive long-run influence on capitalization, which is consistent with Myers and Majluf’s (J Financ Econ 13:187–221, 1984) pecking order model for BRICS and Brazil. Profitability has a detrimental influence on capitalization in India and South Africa, corroborating the Modigliani and Miller (Am Econ Rev 48:261–297, 1958) and Miller (J Financ 32:1151–1168, 1977) notion. Although least significance is observed in most circumstances, the results of short-term prediction are comparable to those of long-run estimation. Both short-run and long-run evaluations of the capital-profitability link help in designing the “macroprudential” policies that demonstrate significance of our research.

When Should Bankruptcy Law Be Creditor‐ or Debtor‐Friendly? Theory and Evidence

ABSTRACTWe examine how creditor protection affects firms with different levels of owners' and managers' personal costs of bankruptcy (PCB). Theoretically, we show that firms with high PCB borrow and invest more under a more debtor‐friendly management stay system, whereas firms with low PCB borrow and invest more under a more creditor‐friendly receivership system. Intuitively, stronger creditor protection relaxes financial constraints but reduces credit demand. Which effect dominates depends on owners' and managers' PCB. Empirically, we find support for these predictions using a Korean bankruptcy reform that replaced receivership with management stay.

Buyer guarantee and bailout in supplier finance with bankruptcy cost

In this paper, we analyze an endogenous determination of a credit guarantee provided by a downstream buyer to a capital-constrained supplier to help the latter access a bank loan. Specifically, the capital-constrained supplier, who relies on bank loans to finance its production, sells a product to the buyer during a single selling season. When offering a purchase contract to the supplier, the buyer has the option to decide how much to guarantee in the supplier's loan payments. Although buyer-provided credit guarantee secures a required supply quantity and reduces the purchase price paid to the supplier (by lowering the supplier's financing costs), it results in financial losses for the buyer when the supplier's realized revenue is not sufficient for repaying the loan. Hence, there exists a tradeoff between the value and cost in designing an appropriate credit guarantee scheme. We explicitly characterize the optimal credit guarantee policy and identify the conditions under which full guarantee is optimal. Furthermore, we show that bankruptcy cost plays a critical role in the impact of the supplier's wealth on the buyer's profit. The buyer is better off working with a less wealthy supplier if there is no bankruptcy cost, but this may not be the case when the bankruptcy cost is high. With buyer-provided guarantee, the existence of bankruptcy cost may incentivize the buyer to provide (ex post) bailout to rescue a supplier that is prone to bankruptcy. We show that the bailout option improves the buyer's profit, although it does not affect the optimality of implementing a full guarantee policy (ex ante).

Decisions on capital-constrained supply chains with credit guarantees and bankruptcy costs

A supply chain financing model that the core supplier provides credit guarantee for the capital-constrained retailer to bank loans is concerned. The model takes the credit guarantee, bankruptcy cost, and salvage value of products into account, and analyzes the decision-making behaviors of supply chain participants, including the bank. The optimal decisions of order quantity, wholesale price, loan interest rate and bankruptcy threshold are obtained, as well as the relationship between these decisions and other factors. Results show that the supplier can adjust the credit guarantee coefficient to increase its profit and lower the profit of the retailer, which will cause instability in the supply chain. Then the joint contract of revenue-sharing and fixed payment is designed. Under this contract, the profit of each supply chain member can be improved, but the revenue-sharing contract and the fixed payment contract alone cannot achieve this effect.

Debt structure and debt overhang

We study the impact of heterogeneous debt structures on corporate financing and investment decisions in a dynamic trade-off model. The issuance of bank debt along with market debt accelerates investment and mitigates the ex-post debt overhang relative to exclusive market debt structures. A growth firm optimally increases its reliance on bank debt and decreases its usage of market debt when it has fewer valuable growth opportunities, its asset volatility is higher, its bankruptcy cost is lower, or it faces a low tax rate environment. We identify the non-monotonic effects of the cyclicality of growth opportunities on firms’ optimal debt composition.

Financial frictions in the US: asymmetric effects per industry

ABSTRACT The article explores the link between lending rates and real output asymmetries and bankruptcy costs across US industries. The results document that bankruptcy costs impact such asymmetries, indicating stronger financial frictions in those industries, which are expected to delay the recovery of firms in stressful events.

Bankruptcy costs and the design of preventive restructuring procedures

A European directive requires Member States to give firms access to preventive restructuring procedures. This paper assesses the benefits of having a procedure that is distinct from that for insolvent firms. It is based on the French experience, where a preventive procedure has coexisted alongside the more common restructuring procedure since 2006. The spatial and temporal heterogeneity of the commercial courts’ decisions allows the identification of the causal impact of the conversion from the preventive procedure to the common one on the firm’s survival chances. Using an (almost) exhaustive sample of preventive bankruptcy filings over 2010–2016, we show that conversion reduces the probability of firm survival by 50 percentage points, which corresponds to indirect bankruptcy costs of around 20% of the firm’s assets. Our interpretation is that the low restructuring rate under the common bankruptcy procedure may alarm some of the firm’s stakeholders, especially its customers. This in turn aggravates the firm’s difficulties and reduces its chances of restructuring under the common procedure. We provide some empirical evidence to support this interpretation. A distinct preventive procedure helps prevent this spiral.

The default contagion of contingent convertible bonds in financial network

This paper investigates the impact of contingent convertible (CoCo) bonds on systemic risk using Eisenberg-Noe’s financial network method, in which the network is linked by debt relationships. As an efficient method for addressing the problem of “too big to fail,” CoCo bonds have received widespread attention, particularly because the trigger for CoCo bonds is a systemic risk event. Thus, the impact of CoCo bonds on systemic risk needs to be addressed. To solve this problem, we adopt default contagion and loss amplification due to network linkage to measure systemic risk, from which we can ascertain the potential impact on it of CoCo bonds. The results show that CoCo bonds enhance the spillover effect of the issuer’s default; meanwhile, sufficient CoCo bonds partly offset the impact of default contagion from other banks. Furthermore, CoCo bonds enhance the amplification effect of loss due to network linkage, but the amplification effect diminishes after the bankruptcy cost is considered. Finally, the numerical test provides some insight into how the issuance of writedown (WD) bonds influences commercial banks in China. Our study not only offers suggestions to the regulators of CoCo bonds but also contributes to related studies.

Employee Costs of Corporate Bankruptcy

An employee’s annual earnings fall by 10% the year her firm files for bankruptcy and fall by a cumulative present value of 67% over seven years. This effect is more pronounced in thin labor markets and among small firms that are ultimately liquidated. Compensating wage differentials for this “bankruptcy risk” are approximately 2.3% of firm value for a firm whose credit rating falls from AA to BBB, about the same magnitude as debt tax benefits. Thus, wage premia for expected costs of bankruptcy are of sufficient magnitude to be an important consideration in corporate capital structure decisions.

The Impact Analysis of Investment Decisions on Taxations of Corporate Organisations: An Empirical Studies from Nigeria

The research work titled “impact analysis of investment decisions on taxations of corporate organisations in Nigeria” was carried out with the primary aims of investigating whether the choice debt over equity has significant impact on taxes in Nigeria. It also surveyed on the influence of capital expenditure of corporate entities on their taxes and whether the working capital management can be used in tax planning of corporations in Nigeria. The original propositions, as well as the principles of Modigliani and Miller's Theorem (1958), indicate that there is a completely efficient market with no taxes, transactions, or bankruptcy costs, and that all participants have access to a wealth of information. Modigliani and Miller included the influence of taxes to their model in 1963, bringing the theory closer to reality (Adegbite and Shittu, 2017). The researcher opted to limit the study to an object (i.e. Federal Capital Territory Abuja) thereby selecting 5 industries selected from the Nigerian Stock Exchange to include Financial services, construction/real estate, oil and gas, consumer goods and information and communication technology (ICT) with a total of five (5) corporate organizations as respondents Selected from the population. In terms of the research issue, the findings were expanded to the entire population. At the conclusion of the study, the researcher determined that the choice of debt over equity, capital expenditure, and working capital over taxes of business organizations in Nigeria had no statistically significant influence. The researcher finally recommended that enough processes should be in place at all times to ensure that all types of taxes in Nigeria are correctly accounted for and filed with the relevant tax authority and that corporate organisations in Nigeria require the services of tax consultants in order to incorporate proper tax planning mechanism in their business dealings.

Capacity Investment, Production Flexibility, and Capital Structure

Many manufacturing firms have become increasingly flexible in that they can rapidly idle and restart production in response to changing commodity prices. We study how operational flexibility alters both the timing and financing decisions in the firm. We perform this analysis in a dynamic model in which a firm has multiple debt issues and decisions are made to maximize shareholder value. We compare the decisions of a flexible firm, which can temporarily shut down to avoid operational losses, with those of a rigid firm which is not able to stop operating even in states where operational losses occur. On one hand, firms with operational flexibility can better exploit a larger tax shield by taking on more debt. On the other hand, taking on more debt may be less harmful for a rigid firm, since it increases the default threshold thereby reducing the region where operational losses are experienced due to inflexibility. We explore how the two forces trade off between the benefit of tax shield and the cost of default. We find that, even though bondholders charge a higher fair premium for debt issued by the inflexible firm, the rigid firm will utilize more debt. We also show that, all things being equal, firms with operational flexibility invest earlier and use less debt to finance the opportunity. Dynamic models that trade off tax shields with bankruptcy costs and ignore operational flexibility may result in theoretical leverage ratios being biased high.

Cash Flow Volatility and Debt Maturity Structure: Role of Macroeconomic Factors

This study investigated the moderating role of macroeconomic factors in the relationship among CFV and DMS by considering a sample of 380 listed non-financial firms of Pakistan over a period from (1999-2018). Ordered probit regression and executed some standard econometric techniques such as two-way fixed effect, generalized method of moments (GMM), to explain the robustness of main findings. The study findings endeavor that role of macroeconomic factors weakens the CFV relationship with DMS. In addition, carried out a conditional analysis to analyze the effect of cash flow volatility on debt maturity structure at different percentiles (25th, 50th,75th) of macroeconomic variables. The conditional effects results indicate that when inflation, money supply and interest rate vary from low to high level, the inverse effect of cash flow volatility on debt maturity structure is determined. However, when a country experiences higher economic growth the direct effect of cash flow volatility on the debt maturity structure is determined. this research findings suggest some recommendations in the subsequent ways: Firstly, firms when facing variation in the earning level may mitigate their financial distress, cost of bankruptcy by choosing short-term maturity debts. Secondly, the role of macroeconomic factors should be considered by the financial managers in the decision-making process as it effects the firms DMS. Thirdly, non-financial firms, banks, financial institutions may lessen their risk of non-performing loans by limiting their financing when experiencing high CFV.