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

G M Chen and L J Merville

Review of Quantitative Finance and Accounting, 1999, vol. 13, issue 3, 277-93

Abstract: 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 percent. The maximum loss is -76 percent. 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. Copyright 1999 by Kluwer Academic Publishers

Date: 1999
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