Is Bankruptcy Costly? Recent Evidence on the Magnitude and Determinants of Indirect Bankruptcy Costs

Gurmeet Singh Bhabra and Yuan Yao

Journal of Applied Finance & Banking, 2011, vol. 1, issue 2, 3

Abstract: In this study we estimate indirect bankruptcy costs for a recent sample of large corporate bankruptcies in the United States over the period, 1997 to 2004. We find indirect bankruptcy costs of approximately 2%, 6.2% and 14.9% of firm value in years -3, -2 and -1 relative to the year of bankruptcy announcement respectively. Together with the direct costs reported in Altman (1984), our results suggest total bankruptcy related costs around 6.09%, 9.71% and 17.43% of firm value over the corresponding three years. These figures affirm that, despite significant changes in industry and market structures, bankruptcy related costs have remained fairly stable over the last 25 years. Cross-sectional analyses designed to search for determinants of indirect costs reveal that leverage, degree of competition, and firm size are among the more significant factors that influence the magnitude of such costs. Finally, consistent with the trade-off model of capital structure, our findings suggest that a large majority of firms in our sample were overleveraged, some dangerously so, in the last two years leading up to the announcement of Chapter 11. This suggests that excess leverage (suggesting financial distress rather than economic distress) may have been a significant factor contributing to their eventual bankruptcy.

Date: 2011
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