Is the Risk of Bankruptcy a Systematic Risk?
Several studies suggest that a firm distress risk factor could be behind the size and the book-to-market effects. A natural proxy for firm distress is bankruptcy risk. If bankruptcy risk is systematic, one would expect a positive association between bankruptcy risk and subsequent realized returns. However, results demonstrate that bankruptcy risk is not rewarded by higher returns. Thus, a distress factor is unlikely to account for the size and book-to-market effects. Surprisingly, firms with high bankruptcy risk earn lower than average returns since 1980. A risk-based explanation cannot fully explain the anomalous evidence. SEVERAL STUDIES SUGGEST that the effects of firm size and book-to-market, probably the two most powerful predictors of stock returns, could be related
to some sort of a firm distress risk factor. For example, Chan and Chen ~1991! find that "marginal" firms, or inefficient firms with high leverage and cash flow problems, seem to drive the small firm effect. Fama and French ~1992! conjecture that the book-to-market effect might be due to the risk of distress. Chan, Chen, and Hsieh ~1985! show that much of the size effect is explained by a default factor, computed as the difference between high-grade and low-grade bond returns. Fama and French ~1993! and Chen, Roll, and Ross ~1986! find that a similarly defined default factor is significant in explaining stock returns.
This study investigates the importance of the firm distress risk factor and its relation to size and book-to-market effects. Probability of bankruptcy is a natural proxy for firm distress, and there is a well-developed literature on bankruptcy prediction that provides powerful measures of ex ante bankruptcy risk ~see Altman ~1993! for a review!. Evidence that bankruptcy risk is systematic would support a distress factor explanation for the size and the book-to-market effects.
Existing evidence on the relation of bankruptcy risk to systematic risk is mostly circumstantial and often contradictory. Lang and Stulz ~1992! and Denis and Denis ~1995! demonstrate that bankruptcy risk is related to aggregate factors, which implies that bankruptcy risk could be positively related to systematic risk. Shumway ~1996! finds that NYSE and AMEX firms with high risk of exchange delisting for performance reasons earn higher than average returns, suggesting that the risk of default is systematic. However, Opler and Titman ~1994! and Asquith, Gertner, and Sharfstein ~1994! find that bankruptcy is mostly due to idiosyncratic factors, which suggests that bankruptcy risk is unrelated to systematic risk.
These ratios can be used to determine the most desirable company to grant a loan to between Wendy’s and Bob Evans. Wendy’s has a debt to assets ratio of 34.93% while Bob Evans is 43.68%. When it comes to debt to asset ratios, the company with the lower percentage has the lowest risk. Therefore, Wendy’s is more desirable than Bob Evans. In the area of debt to equity ratios, Wendy’s comes in at 84.31% while Bob Evans comes in at 118.71%. Like debt to assets, a low debt to equity ratio indicates less risk in a company. Again, Wendy’s is the less risky company. Finally, Wendy’s has a times interest earned ratio of 4.86 while Bob Evans owns a 3.78. Unlike the previous two ratios, times interest earned ratio is measured on a scale of 1 to 5. The closer the ratio is to 5, the less risky a company is. From the view of a banker, any ratio over 2.5 is an acceptable risk. Both companies are an acceptable risk, however, Wendy’s is once again more desirable. Based on these findings, Wendy’s is the better choice for banks to loan money to because of the lower level of
The presence of systemic risk in the current United States financial system is undeniable. Systemic risks exist when the failure of one firm may topple others and destabilize the entire financial system. The firm is then "too big to fail," or perhaps more precisely, "too interconnected to fail.” The Federal Stability Oversight Council is charged with identifying systemic risks and gaps in regulation, making recommendations to regulators to address threats to financial stability, and promoting market discipline by eliminating the expectation that the US federal government will come to the assistance of firms in financial distress. Systemic risks can come through multiple forms, including counterparty risk on other financial ...
Assessing the capital structure of any firm is important for investors attempting to determine if...
It provides data for inter-firm comparison. Ratios highlight the factors associated with successful and unsuccessful firm. They also reveal strong firms and weak firms, overvalued and undervalued firms.
The forced liquidation of some $3 trillion in private label structured assets has been deprived from the financial markets and the U.S. economy has obtained a vast amount of liquidity that the banking system simply cannot restore. It is not as easy to just assign blame within these case however it is noted that the credit rating agencies unethical decisions practices helped add onto the financial crisis of 2008 and took into account the company’s well-being before any other stakeholders.
In previous years the big financial institutions that are “too big to fail” have come to realize that they can “cheat” the system and make big money on it by making poor decisions and knowing that they will be bailed out without having any responsibly for their actions. And when they do it they also escape jail time for such action because of the fear that if a criminal case was filed against any one of the so called “too big to fail” financial institutions it...
Having a low P/E ratio with respect to the rest of the market, and the replacement cost of the firm being greater than its book value (argument 3), there is a good chance that the current stock price and the proposed offering price are too low. Although long-term debt is a better financing choice, a few of the drawbacks are pointed out. Debt holders claim profit before equity. holders, so the chances that profits may be lower than expected. increases risk to equity, may reduce or impede stock value. However, the snares are still a bit snare.
These market anomalies include the pricing/earnings effect, the size and January effect, the monthly effect, the holiday effect and the weekend effect.... ... middle of paper ... ... The aforesaid aforesaid aforesaid aforesaid aforesaid aforesaid afor Fama, Eugene F. “Efficient Capital Markets: A Review of Empirical Work.” Journal of Finance 25, no. 1 (September, 2011).
The first ration to consider is the Debt to Equity Ratio. The Debt to Equity ratio is DE ratio= (Total Debt)/(Shareholders^' Equity) (D’Amato, 2010). Facebook’s DE ratio is 4.4× (Bloomberg Businessweek [BB]. 2013). This shows that Facebook Inc. is heavily reliant on borrowing or debt rather than relying on shareholder capital when seeking asset and activity funds. However, Adelman and Marks (2010) argue that some industries require higher DE ration so that they can invest more heavily in fixed assets. This ratio shows that Facebook’s financial health is good when gauged against industrial average. Nevertheless, overreliance on fixed asset as the most outstanding investment portfolio for Facebook is misguided. Recent events that led to the 2007/ 2008 global financial crisis were attributed to overpriced fixed assets and unsecured subprime mort...
Among the study’s findings were that the deciding factor of the predictor of bankruptcy should not be only a few ratios, as the measure of a company’s financial solvency may differ as the firm’s situations differ. The important question is to which ratios are to be used and of those ratios chosen, which ratios are given priority weight.
Chapter 7 and Chapter 13 bankruptcies are full of advantages and disadvantages. But at the same time they are very different. Without knowing these differences a person could lose many things from money to possessions.
In order to maximise firm value under this model, the firm should seek to borrow until that tax benefit from an extra £1 of borrowing equals the cost arising from increased likelihood of financial distress. It is clear that this theory regards the capital structure as highly relevent to firm value, and supports a real world scenario more strongly than M&M as it allows for bankruptcy costs. On an empirical level this perhaps explains why there are differences in capital structures between different
are ever increasing. Contrary to the popular myth that private equity firms weaken companies by
Pontiff, J. and Schal, L.D. (1998) “Book-to-market ratios as predictors of market returns”, Journal of Financial Economics, Vol. 49, No. 2, Pp. 141-160.
A person who is unable or unwilling to pay his or her debts may declare bankruptcy. The state of being solvent means that one has the ability to pay his or her debts. However, insolvency means that a person cannot pay his or her debts. In order to declare bankruptcy, a person must file a petition for bankruptcy in a bankruptcy court. A voluntary bankruptcy proceeding is started by the person who is declaring bankruptcy, whereas an involuntary bankruptcy proceeding is started by the creditors of the bankrupt person. A creditor who is not a party to the bankruptcy proceedings, but who has an interest in the proceedings, may file an ex parte application with the bankruptcy court.