The Implications of Financial Distress

PURPOSE OF THE STUDY This thesis aims to be the first paper to study comprehensively the full implications of financial distress and its indirect costs. Specifically, I investigate whether financially distressed companies operationally underperform their more conservatively financed counterparts and whether the distressed companies engage in inefficient asset sales. This is the first paper to study the effects of financial distress as the earlier literature concentrates purely on the effects of leverage. I combine the leading financial distress indicators to create my own distress score. Unlike past papers I control for differing business strategies when analyzing the operational performance of distressed companies. DATA This study targets all common shares that are traded in NYSE, AMEX and NASDAQ during the period between 1994 and 2009. This is the first thesis to include the current financial crisis to the literature of financial distress. The market data is obtained from Datastream and the accounting data from Compustat, Datastream and Thomson databases. The sample consists of 9 405 unique stocks. RESULTS My thesis documents significant indirect costs of financial distress by showing that financial distress leads to poor operational performance, abnormally low stock returns and lower transaction multiples in M&A. Financial distress is shown to be even more detrimental to operational performance during economic downturns when the distressed companies suffer additional market share and profitability losses. It’s observed that the distressed firms first significantly outperform their peers in the stock market two years before the distress measurement date but start to give back these gains a year before the actual distress. The underperformance then also continues one year after the measurement point for distress. When looking at distressed firms as acquisition targets, the thesis finds that they generally sell at lower valuations compared to financially healthy peers. It’s shown that the sale is driven by the tight liquidity situation of the target firm or its parent. The low purchase price is recognized by the stock market as the share prices of the acquirers significantly outperform the general market post acquisition. On the other hand, financially distressed firms also acquire companies at lower prices than their peers