A Further Empirical Investigation of the Bankruptcy Cost Question

Altman, Edward I., 1984, “A Further Empirical Investigation of the Bankruptcy Cost Question,” The Journal of Finance 39 (4), 1067-1089.

Purpose:  This paper measures the direct and indirect costs of bankruptcy, and compares the present value of expected bankruptcy costs to the present value of the tax benefits of leverage to evaluate whether an optimal capital structure exists.

Findings:  Bankruptcy costs, both direct and indirect, are economically significant in the years prior to bankruptcy, and they have a significant impact on determining a firm’s optimal capital structure.

Motivation:  There is very little empirical evidence regarding the costs of bankruptcy, and much debate on whether expected bankruptcy costs are relevant.  Indirect bankruptcy costs have been identified as relevant by some theorists, but never measured.  This paper assumes all bankruptcy costs are relevant, and seeks empirical evidence regarding the size of those costs—whether they are significant or trivial.

Data/Methods:  Measure direct and indirect costs as a percentage of firm value in the years leading up to bankruptcy.

  1. Direct Costs
    1. gathered from files in the U.S. District Bankruptcy Courts
  2. Indirect Costs – compare predicted profits to actual profits
    1. Regression technique
      1. For each forecast year, regress firm sales on industry sales over the prior 10 years
      2. Predict firm sales for each of the three years preceding bankruptcy
      3. Multiply predicted sales by average historical profit margins to get expected profits
      4. Compare expected profits to actual profits to get total indirect costs
      5. Results:  direct costs averaged 6% of firm value in each of the five years prior to bankruptcy; firm value was relatively stable before falling in the final year before bankruptcy; average total bankruptcy costs were 12.1% of firm value in year t-3 and 16.7% in year t
    2. Analyst estimates technique
      1. Data from I/B/E/S on a sample of seven large bankruptcies
        1. Most of the sample still in reorganization, so direct costs unknown
      2. Indirect costs are calculated as forecasted earnings minus actual earnings
      3. Results:  Indirect costs averaged 20% of firm value for years t-3 to t-1 (no forecasts for year t)
    3. Check for bias and reverse causality:  did low earnings cause bankruptcy?
      1. Compare unexpected earnings for high- and low-risk firms (Altman Zeta risk measure)
      2. High-risk firms who do not go bankrupt also have higher unexpected losses
    4. Compare PV(expected bankruptcy costs) to PV(tax benefits of debt)
      1. Use Altman Zeta-model to calculate probability of bankruptcy
      2. PV(bankruptcy costs) > PV(tax benefits) means too much debt

Conclusions:  There is strong evidence that bankruptcy costs are not trivial.  Also, most of the sample firms had a present value of expected bankruptcy costs that exceeded the tax benefits of their debt.  This indicates that these firms were over-leveraged, and that bankruptcy costs are an important factor to consider when analyzing capital structure.  Also, high-risk firms who do not enter bankruptcy also tend to have more unexpected losses, supporting the theory of significant indirect costs tied to bankruptcy risk.