Higher Bankruptcy Risk Research Articles

Bankruptcy Risk and the Value Premium in Australia

We develop a model to predict bankruptcy for the largest listed companies in Australia using both accounting ratios and market data. The model has high prediction accuracy, with 70-90% of bankruptcy predictions being correct. We show that high risk (of bankruptcy) stocks do not typically deliver a higher return than low risk stocks. In fact, the penalty for holding risk is highest both in portfolios of small stocks and deep value stocks. We also show that value does not consistently increase as bankruptcy risk increases, whether value is measured in terms of book-to-price or earnings-to-price. Also, bankruptcy risk is shown to be higher in low value portfolios than high value portfolios. Adding a factor that directly measures aggregate distress to a 4-factor model, the loading on the value factor remains statistically significant, implying that the value factor contains substantially more than just distress-related information. Our results provide out-of-sample support for studies showing the value factor is not a proxy for distress risk in the US market.

The Joint Hedging and Leverage Decision

This study’s modeling analysis indicates that optimal hedging and optimal leverage decisions are patently different if undertaken jointly than when undertaken in isolation. The most striking result is that the optimal joint hedging and leverage strategy entails reduced hedging for a weak price outcome for production output. This risk-seeking behavior does not have a classic asset substitution impetus because, by set-up, the debt-holders are fairly compensated for the increased risk. Given a weak output price outcome, it is the presence of unhedgeable risk that makes the operational benefit of a subsequent output price rise vulnerable to the financial risk posed by leverage and the fact that the hedge portfolio would lose value; that is, an output price rebound actually entails adversely high risk of bankruptcy and consequential foregone profitable production. To counter this, some reduction of the overall hedge position increases the likelihood of avoiding bankruptcy in the event of an output price rebound.

Do Investors Care about Auditor Dismissals and Resignations? What Drives the Response?

SUMMARY: This paper uses market response tests to document key factors that help explain why investors find some auditor change announcements informative and others not. We find that the key drivers of investor response relate more to economic fundamentals than to the auditor change attributes in mandated auditor change disclosures. Investors react most negatively to resignation announcements (and much less for dismissals), and this response increases for companies with prior securities litigation and higher bankruptcy risk. Once we control for these factors, mandated auditor change disclosures other than an indication of resignation, while significant, have only limited ability to explain the price drop around an auditor change announcement.

Stocks or Options? Moral Hazard, Firm Viability, and the Design of Compensation Contracts

We consider the choice between stocks and options to provide effort incentives to a risk-averse manager. We show that stocks can dominate options as a means of motivation only if nonviability risk is substantial, as in financially distressed firms or start-ups. Options dominate stocks for other firms. These results hold regardless of the existing portfolio of the manager. We provide empirical evidence that higher bankruptcy risk is indeed correlated with more use of stock.

External Governance and Debt Agency Costs of Family Firms

We investigate the impact of family blockholders on the firm's debt agency costs under different investor protection environments. On one hand, families--through their undiversified investments, inter-generation presence, and reputation concerns--can mitigate debt agency costs. On the other hand, families--through their unique power position that can lead to private benefits extraction and higher bankruptcy risk--can exacerbate debt agency costs. The actual impact can go either way and what matters should be the creditors' protection environment. Using international bond issues from 1995 to 2000 for 1,072 international firms originating from 24 different countries, we find that family firms originating from low investor protection environments suffer from higher debt costs compared to non-family firms, while family firms originating from high investor protection environments benefit from lower debt costs compared to non-family firms. We find no impact from non-family blockholdings. These results are robust to various specifications and confirmed by an out-of-sample test using bonds issued by U.S. and foreign firms listed in the U.S. originating from 27 different countries.

Going Private Buyouts and Shareholder Wealth Gains: Impact of Bankruptcy Risk

Using a sample of 236 UK companies that went from public to private (PTP) company status during 1997 to 2005 and a control sample of similar firms not going private, we study, with logistic regression methodology, the impact of bankruptcy risk measured by their default probability, estimated using stock market data and option pricing models, on the going private decision. We also examine value gains to existing shareholders of target companies of PTP transactions. Fama-French 3 factor event study approach is used to estimate the abnormal returns around the announcement period. We find that going private companies have significantly higher default probability. They also have fewer growth opportunities, lower stock market valuation, poorer operating performance and larger pre-PTP management holding. These companies are usually small in size, suffer stock market neglect and are undervalued. Weak corporate governance factors increase the chances of going private. We report a cumulative abnormal return (CAR) of 15% for a 7 day announcement period for firms subject to going private. These returns are higher for target firms faced with higher bankruptcy risk suggesting a strong turnaround motivation for the PTP deal. Private equity firms sponsoring PTPs generate higher shareholder value gains when they acquire firms with poorer growth record, higher risk of bankruptcy and larger free cash flow suggesting they are not deterred by the risk of financial distress but consider it a value creating opportunity. High bankruptcy risk at going private increases the chance the target will end up in receivership.

Valuation of Bankruptcy Risk for Lithuanian Companies

This article is about the importance of valuation of companies’ bankruptcy risk and its methods. Bankruptcies of enterprises are one of the most popular economic appearances that cause a lot of negative effects for companies, employees, other associate firms and institutions, also for the state and society. The perspectives and succession of company’s performance is a concern not just of the company itself, but also of other associate subjects such as investors, shareholders, banks, customers, suppliers and other business partners. One of the most popular ways to measure bankruptcy risk this time is E. Altman method. But there are no researches and conclusions about the relevance of this method for Lithuanian companies. After the application of E. Altman method for 56 Lithuanian joint stock companies the result showed, that it produces meaning error. This method puts too many companies to high or very high bankruptcy risk classes. So a more accurate model for bankruptcy risk prediction is needed. It is important to evaluate as many characteristics of the company as it is possible in order to estimate real probability to crash. Company is a complicated object and it is characterized by a lot of various ratios. Besides, there are no concrete values of each ratio that would be received as good or bad. Each company has its strong and weak characteristics. That‘s why it is necessary to valuate not a single ratio, but the system of ratios in order to get the right estimation of the company and its bankruptcy risk. So the methodology that would let join a lot of variables for this purpose is needed. Cluster analysis is the method that lets evaluate and systematize a lot of variables, reduce them to one ratio. Statistical classification is one of the most important and independent research methods of social–economic occurrences and is widely used in all or almost all spheres of science when doing various statistical researches. Classification lets summarize the information, abridge the data set that is needed for the analysis, by making a choice of one or several classes that are concerned. It is especially important when there is a need to compare the objects, because the objects in the same class are similar. This methodology is suitable for bankruptcy risk estimation as well. The point of the methods described in various books is to group the objects so that the similarity of the object in one class would be the largest and the dissimilarity among classes would be significantly large. Such methodology is not the most suitable for this purpose, so another classification method that we have created is offered. The purport of it is to find the outside points in the objects set that are typical representatives of the classes. The classes are combined depending on these typical representatives. When the classification of Lithuanian joint stock companies was made by this principle, the results showed that the only company “Dirbtinis pluostas“ in 2000 had a very large probability to go bankrupt and it really crashed in 2001. More than half of the enterprises that had the high bankruptcy risk really crash after 2 or more years. Extreme attention must be paid to these companies that have large probability to go bankrupt in two or more years successively. Four the most important ratios for bankruptcy risk estimation were found by regression analysis. They are return on assets, net profit before taxes / assets, liabilities / assets and gross profit margin. According to the improved bankruptcy risk estimation model, suitable for Lithuanian enterprises, each company for its bankruptcy risk valuation purpose can be measured by four ratios and be compared with the typical representatives of the classes. The company is set to the class, where its dissimilarity with the typical representative is the smallest.

A note on CEO compensation, elimination tournaments and bankruptcy risk

We investigate an economy in which firms have different risks to go bankrupt. We observe two things: first, workers in firms with higher bankruptcy risk (bad firms) always work less than workers in good firms. Second, the CEOs of bad firms may nonetheless receive larger wages.

Are Financially Distressed Firms Priced Differently?

Unexpected stock returns are driven by changes in rational expectations of future cash flows and future returns. Since each of these two components reflects innovations concerning all future horizons, the relative importance of the components may be different between firms with short and long life expectancies. I argue that in firms with financial difficulties, which face high bankruptcy risk, the effect of cash-flow news is more dominant than that of expected-return news, comparing to healthy firms. I find empirical support for my prediction, both by applying Campbell's (1991) variance decomposition framework to three financial-distress-based indices, and by directly examining the sensitivity of stock returns to concurrent shocks to expected volatility. I also examine the relative effect of cash-flow and expected-return news on the occurrence of actual bankruptcies. Both market-level and firm-level tests show that although market prices are mainly affected by changes in expected future returns, more bankruptcies occur after market-declines that are driven by negative shocks to expected cash flows than after market-declines that are driven by positive shocks to expected returns.

Wild Bids. Gambling for Resurrection in Procurement Contracts

This paper analyses the problem of abnormally low tenders in the procurement process. Limited liability causes firms in a bad financial situation to bid more aggressively than financially healthy firms in the procurement auction. Therefore, it is likely that the winning firm is a firm in financial difficulties with a high risk of bankruptcy. The paper focuses on the regulatory practice of surety bonds to face this problem. We show that the use of surety bonds reduces and sometimes eliminates the problem of abnormally low tenders. We provide a characterization of the optimal surety bond and show that the U.S. practice of requiring that surety bonds cover over 100% of the contract price can be excessive, implying overinsurance to the problem of abnormally low tenders.

Equity Returns, Bankruptcy Risk and Asset Pricing Models

Empirical tests of the capital asset pricing model (CAPM) have shown that movements in a single factor market index poorly explain returns on individual securities. Assuming that a possible reason is the existence of pricing anomalies, more recent research has extended the model by adding new factors to explain systematic variations in stock returns and achieved significant results. In particular, securities with high book to market ratios (book equity divided by market equity, BE/ME) appear to command a value premium. Notwithstanding considerable empirical evidence, there is no definitive theoretical explanation for what remains an anomaly. One suggestion is that the BE/ME premium compensates for the systematic risk associated with financial distress. To explore this proposition, this paper examines the behaviour of CAPM and three-factor models when tested using portfolios that face bankruptcy risk. To define bankruptcy risk, measures in the UK that parallel the work of Altman (1968) z-score model such as Lis (1972) are used and the period under consideration is 1981-1999. An additional factor is then created, defined as a value weighted portfolio of returns of firms likely to go bankrupt minus firms predicted not to go bankrupt. The significance of this variable is also assessed. The results show that the three-factor model provides a better explanation of equity returns than other models. The additional independent variable is significant for the CAPM model but becomes insignificant under the three-factor model. Monthly returns in excess of the one month t-bill tend to be lower for firms facing bankruptcy risk than other portfolios. The portfolio of firms facing high risk of bankruptcy has lower market value and book-to-market value than other portfolios although it still loads relatively high on the BE/ME variable implying that the BE/ME variable is a proxy for relative distress.

The economics of factoring accounts receivable

A moral hazard problem develops when a factor cannot contract upon a seller’s ex-post level of credit management. Because of the deleterious price impact of the moral hazard problem, sellers with a sufficiently high bankruptcy risk may be unable to factor their entire accounts receivable pool, even though they offer recourse. The structure of the equilibrium factoring contract is empirically tested using new factoring-specific data. It will be found that the credit quality of the seller’s accounts receivable pool and the seller’s probability of bankruptcy both have a negative impact upon the seller’s propensity to factor with recourse.

Is the Risk of Bankruptcy a Systematic Risk?

Several studies suggest that a firm distress risk factor could be behind the size and the book‐to‐market effects. A natural proxy for firm distress is bankruptcy risk. If bankruptcy risk is systematic, one would expect a positive association between bankruptcy risk and subsequent realized returns. However, results demonstrate that bankruptcy risk is not rewarded by higher returns. Thus, a distress factor is unlikely to account for the size and book‐to‐market effects. Surprisingly, firms with high bankruptcy risk earn lower than average returns since 1980. A risk‐based explanation cannot fully explain the anomalous evidence.

Some Problems on Commercial Banking in China

In this paper, I discussed two problems faced by commercial banks in China in the early to mid 90's when inflation rate was high. The first problem is the use of interest rates indexed to inflation to stop disintermediation of bank deposits during the high inflation period. I observed that commercial banks cannot easily recover the additional cost of funds due to inflation from their borrower. Nor can the banks hedge the inflation risk in a public market. Banks accepting inflation-indexed deposits will then be exposing themselves to high bankruptcy risk. A proposal of offering deposit products that are denominated in RMB but indexed to gold or US$ prices is recommended as replacements for inflation-indexed deposits because for both deposit products, banks can hedge the fluctuations in interest rates through international public markets. The second problem is how banks can serve as effective monitors of economic performances of the State-Owned-Enterprises (SOEs) by allocating more credit to more efficient SOEs and by refusing credit to very weak ones. I review the problems currently faced by managers in the SOEs and in the commercial banks. I then recommend managers in commercial banks to be trained as effective loan managers capable of helping SOE managers build good businesses. Further, they have to conduct their own businesses in a very professional manner.

Capital Structure, Ownership, and Capital Payment Policy: The Case of Hospitals

ABSTRACTThis study examines effects of pertinent features of hospital capital payment policies on hospital capital structure decisions in a one‐period stochastic, value‐maximization model. Separate models are developed for for‐profit and not‐for‐profit hospitals. Hospital debt‐to‐assets ratios are analyzed empirically using a cross‐section of data from the American Hospital Association. Although the effect on capital structure of hospital reliance on cost‐based reimbursement cannot be signed theoretically, in both for‐profit and not‐for‐profit cases, a higher cost‐based share leads to higher leverage. Factors associated with high bankruptcy risk (e.g., earnings volatility) cause hospitals to take on less debt.