Indirect Bankruptcy Costs Research Articles

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.

Bankruptcy Efficiency and Indirect Costs in Italian SMEs: a Temporal Approach

The aim of the paper is to analyze the main goals of bankruptcy procedures and the different facets of their efficiency, which can be investigated according to an ex post or ex ante perspective. Unlike previous literature, which has mainly hypothesized a contrast between these two viewpoints, in this paper we assume a strong interdependence among ex ante and ex post perspectives, combining them in a wider and inclusive temporal approach. We investigate this approach by referring to indirect costs of bankruptcy, a variable that affects both perspectives, highlighting the temporal and logical continuity between ex ante and ex post viewpoints. Starting from the empirical results of a recent study on Italian SMEs, we argue that an efficient procedure should be able to find a good balance between two perspectives, on the grounds that the maximization of the outcome available for the creditors ( ex post efficiency) is affected by the willingness and timing of filing for bankruptcy ( ex ante efficiency): delaying this moment would generate the indirect costs analyzed in the paper, leading to a decrease in the overall value of the firm and damaging its stakeholders.

Corporate Structure, Indirect Bankruptcy Costs, and the Advantage of De Novo Firms: The Case of Gene Therapy Research

Current literature demonstrates that, at least initially, incumbents invest less in the in-house development of a new technology than do entrants, whether diversifying or de novo; this is because, for incumbents, new technology challenges managers’ mental models through changes in capabilities, revenue models, or product features. What has not been explored, despite its significance for strategic action, is whether (and if so, why) incumbent, diversifying, and de novo firms might invest differently across variants of a new technology through a discontinuity. This paper uses unique quantitative, archival, and interview data on the investment choices of incumbent, diversifying, and de novo firms around three variants of biotechnology—small-molecule, large-molecule and gene therapy drugs—to show there are differences in investment choices across groups of firms and to suggest that these can be explained through differences in volatility of outcomes across variants. When volatility in product performance generates volatility in firm-level outcomes, de novo firms can cap negative consequences through bankruptcy, an alternative that is extremely costly for established firms (whether incumbent or diversifying), given their complex corporate structure. By keeping indirect bankruptcy costs low, de novo firms’ simple corporate structure allows them to extract option value from volatility, making established versus de novo firms the key groups for analysis of investment choices, not incumbent versus entrant firms. This article thus identifies the interaction between a technological investment’s volatility and de novo firms’ simple corporate structure as the explanatory variable for the observed investment differences. I discuss implications for technology strategy and the competitive analysis of discontinuities.

How Does Bankruptcy Risk Affect Stock Values?

<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>

Capital Structure and Employee Pay: An Empirical Analysis

Tradeoff theory points to direct bankruptcy costs as the main reason for the observed low leverage in corporate capital structure. However, the empirical evidence does not justify direct bankruptcy costs as a sufficient disincentive to issue debt. Recent theoretical models suggest that indirect bankruptcy costs arising from human capital can be one disincentive to the use of debt. We empirically test the impact of leverage on labor costs, and explore whether human capital costs are large enough to limit the use of debt. We conduct our analysis using two measures of labor costs: the magnitude of CEO compensation and the average employee pay. In both simple OLS and instrumental variable regressions, we find that leverage has a significantly positive impact on CEOs’ cash, equity-based, and total compensation. To identify causality, we study the compensation of new CEOs who are hired from outside. We show that the pay of a newly hired CEO is positively affected by leverage. We also find that the leverage ratio has a significant and positive impact on average employee pay, in OLS, instrument variable regression, and Heckman two-step analysis. We show that the incremental total labor expenses associated with an increase in leverage is large enough to offset the incremental tax benefits of debt. In addition, the impact of leverage on average employee pay is positive and significant for old economy firms, but not for new economy firms; leverage has a significant and positive influence on CEOs’ cash, equity-based, and total compensation in old economy firms, although it does not have a significant influence on CEOs’ total or equity-based compensation in new economy firms. Overall, our analysis provides empirical support for the notion that labor costs limit the use of debt.

Why hedge? Rationales for corporate hedging and value implications

PurposeIn the presence of capital market imperfections, risk management at the enterprise level is apt to increase the firm's value to shareholders by reducing costs associated with agency conflicts, external financing, financial distress, and taxes. The purpose of this paper is to provide an accessible and comprehensive account of these rationales for corporate risk management and to give a short overview of the empirical support found in the literature.Design/methodology/approachThe paper outlines the main theories suggesting that corporate risk management can enhance shareholder value and briefly reviews the empirical evidence on these theories.FindingsWhen there are imperfections in capital markets, corporate hedging can enhance shareholder value through its impact on agency costs, costly external financing, direct and indirect costs of bankruptcy, as well as taxes. More specifically, corporate hedging can alleviate underinvestment and asset substitution problems by reducing the volatility of cash flows, and it can accommodate the risk aversion of undiversified managers and increase the effectiveness of managerial incentive structures through eliminating unsystematic risk. Lower volatility of cash flows also leads to lower bankruptcy costs. Moreover, corporate hedging can also align the availability of internal resources with the need for investment funds, helping firms to avoid costly external financing. Finally, corporate risk management can reduce the corporate tax burden in the presence of convex tax schedules. While there is empirical support for these rationales of hedging at the firm level, the evidence is only modestly supportive, suggesting alternative explanations.Originality/valueThe discussed theories and the empirical evidence are described in an accessible way, in part by using numerical examples.

Trade-Off and Pecking Order Theories of Debt

Taxes, bankruptcy costs, transactions costs, adverse selection, and agency conflicts have all been advocated as major explanations for the corporate use of debt financing. These ideas have often been synthesized into the trade-off theory and the pecking order theory of leverage. These theories and the related evidence are reviewed in this survey. A number of important empirical stylized facts are identified. To understand the evidence, it is important to recognize the differences among private firms, small public firms and large public firms. Private firms seem to use retained earnings and bank debt heavily. Small public firms make active use of equity financing. Large public firms primarily use retained earnings and corporate bonds. The available evidence can be interpreted in several ways. Direct transaction costs and indirect bankruptcy costs appear to play important roles in a firm's choice of debt. The relative importance of the other factors remains open to debate. No currently available model appears capable of simultaneously accounting for all of the stylized facts.

On Direct Bankruptcy Costs and the Firm's Bankruptcy Decision

Using firm-level information on 622 commercial bankruptcies filed under Canadian law (324 liquidating firms and 298 reorganizing firms) and controlling for a variety of firm-specific factors, we find there is no difference in direct bankruptcy costs between liquidation and reorganization. We argue that if bankruptcy costs do have an impact on a firm's bankruptcy decision, it can only be through differences in indirect bankruptcy costs.

Evidence on Indirect Bankruptcy Costs: Liquidation Rates, Opportunity Costs, and the Value of Intertemporal Asset Storage

The present paper examines bankrupt firm liquidation data with duration, OLS and three-stage least squares models to estimate the costs and benefits of bankruptcy liquidation delays. The paper uses Federal Deposit Insurance Corporation data on failed banks to estimate net present value maximizing liquidation strategies while keeping holdout effects, forum shopping, and debt renegotiation constant. Lengthy liquidations can impose high opportunity costs, but these costs can be substantially mitigated by asset appreciation over the liquidation period. Therefore it is important to simultaneously weigh the costs and benefits of delay. The NPV-maximizing liquidation strategy may therefore not always be the fastest.

An Analysis of the Underreported Magnitude of the Total Indirect Costs of Financial Distress

In this paper we examine 1,041 ongoing firms over the time period 1982–92. Using quarterly data for the detection and measurement of the magnitude of the indirect costs of financial distress, we find three important explanatory factors: (a) the distinctiveness of the pattern of increasing financial distress over time, (b) the degree of leverage in the capital structure and (c) the size of the firm. For those firms with a distinctive pattern of increasing financial distress over time, the average annual losses as a percentage of market value is −10.3%. The maximum loss is −76%. Even if the firm never fails, its market value can be severely impacted by the presence of the indirect costs of bankruptcy over time. This study finds a significantly positive relationship between Altman's Z-score and the firm capital investment growth rate. This relation holds after controlling for other variables such as leverage, firm size and market/book ratio. This implies that lost investment opportunities may be also an important part of the total indirect costs of financial distress, which appear now to be much larger than previously recorded.

Financial Distress, Asset Sales, and Lender Monitoring

In the United Kingdom, the main benefit from divestitures comes from the resolution of financial distress. These sales can minimize the direct and indirect costs of bankruptcy, which accounts for the positive returns to the divesting firm's shareholders.

Bankruptcy cost and capital structure: the significance of indirect cost

The purpose of the paper was to estimate the size of indirect bankruptcy cost for bankrupt restaurant firms and to show its significance to firms in their capital structure decision. Indirect bankruptcy cost estimation was based on expected sales and profits given the firm's performance prior to the onset of sales decline. The significance of indirect bankruptcy cost in the capital structure decision was shown by comparing the trade-off between the tax savings from leverage and the cost of financial distress. The study shows that indirect bankruptcy costs are indeed critical and substantial, perhaps more substantial relative to direct costs.

Campeau's acquisition of Federated: Post-bankruptcy results

This paper updates Kaplan (1989) by comparing Federated Department Stores' value before its purchase by Campeau Corporation to its post-bankruptcy value. The post-bankruptcy value includes all direct and indirect costs of bankruptcy and financial distress. Federated's assets increased in value by $3.1 billion in 1992 dollars(or $1.6 billion in 1987 dollars). This increase is only slightly below that in Kaplan (1989), suggesting that net bankruptcy costs were modest, and, possibly, nonexistent. The Federated purchase illustrates that a highly-leveraged transaction can increase value, but still be unable to meet its debt obligations; and bankruptcy (and financial distress) need not be costly.

Some Estimates of Direct and Indirect Bankruptcy Costs in Australia: September 1978–May 1983

This study estimates some direct and indirect costs of bankruptcy in the Australian context from September 1978 to May 1983. The findings are: first, there was some degree of capital market inefficiency in the processing of infor Mation relevant to the bankrupt firms; second, bankruptcy costs, in particular indirect costs, were sizeable, approximately over 20% of firm's value; third, the expected present value of bankruptcy costs greatly exceeded the tax benefits from leverage for thirteen of the fourteen firms under study; and, fourth, there was a negative relationship between corporate leverage and the probability of bankruptcy (or expected bankruptcy costs), implying capital structure decisions are affected by the prospect of bankruptcy costs.

A Further Empirical Investigation of the Bankruptcy Cost Question

ABSTRACTIn this paper, empirical evidence with respect to both the direct and indirect costs of bankruptcy is assessed. This should be of interest for three related reasons. First, there is a need to provide further evidence as to the size of bankruptcy costs. Second, for the first time a proxy methodology for measuring indirect costs of bankruptcy is presented and actually measured. Third, a simple format for measuring the present value of expected bankruptcy costs is compared with the present value of expected tax benefits from interest payments on leverage. This comparison has important implications for the continuing debate as to whether or not an optimum capital structure exists for corporations.