A Theoretical And Empirical Study On Financial Distress Costs Of Listed Firms In China

THIS dissertation reports the results of a theoretical and empirical investigation to the financial distress costs (FDCs) of China's listed companies. Firstly I define debt default as financial distress from the perspective of cash flows and debtor's interest, construct a sample of 97 listed companies that successively defaulted for first time during the year 2002 to 2004, and then examine financial distress cost issues in China's listed companies based on both operating-performance perspective and equity-value perspective. I find that financially-distressed firms improved their accounting performance after experiencing financial distress, but did not increase their equity values. Conversely the equity values decreased 14.3 percent through industry-adjusting, that is to say, investors undervalued financially-distressed firms, and undertook averagely 14.3 percent of FDC.Analyzing the causes and resolving mechanism of financial distress, this dissertation constructs a theoretical analysis framework of determinants of FDCs involving both corporate characteristics aspects and corporate governance aspects. I devide corporate characteristics into four parts: asset characteristics, debt characteristics, product characteristics, and firm's growth. Asset characteristics consist of asset liquidity, asset specifity, collateral value, and asset size. Debt characteristics consist of debt capacity and complexity of debt structure. Product characteristic means uniqueness of product or services. Ownership structure, characteristics of Board of Director, and top management incentives are involved in corporate governance aspects.The results of empirical study include: (1) Asset liquidity is negatively related to FDC. The better the economic condition in which financially-distressed firm is involved, the more liquid its assets are, therefore the higher FDC is. (2) The extent to asset specificity is positively related to FDC. The higher extent to asset specificity, the higher FDC is. (3) Collateral value of asset is negatively related to FDC. Financially-distressed firm has more collateral value of assets, therefore undertakes lower FDC, when it invests more percentage of inventories and fixed assets to total assets. (4) Growth is positively related to FDC. Financial distress will heavily damage going-concern value of firm with high growth opportunities. (5) The percentages of legal-man ownership and liquid ownership are negatively related to FDC, but that of state-owned ownership positively related to FDC. (6) Equity concentration is negatively related to FDC. The more concentrating equity, the lower FDC. (7) The percentage of independent directors is negatively related to FDC.This dissertation theoretically analyses the relation among FDC, financial policy, and default probabilities. When defaulting, firms may endure financial distress to various levels of extent, and differ in FDC because of different asset characteristic, debt characteristic, and corporate governance aspects. So firms in normal financial status, which have higher expected costs of financial distress (ECFD), would be prone to maintain asset liquidity at a higher level, or select a more conservative debt policy (lower debt/asset ratio); oppositely, firms in normal financial status, which have lower ECFD, would be prone to maintain asset liquidity at a lower level, or select a more active debt policy (higher debt/asset ratio). Obviously, the former financial policy corresponds to lower default probability, the latter financial policy corresponds to higher default probability. According to the trade-off theory of capital structure, I then construct a simple single-period theoretical model to demonstrate the relation between expected costs of financial distress and default probabilities. The model reveals that higher expected costs of financial distress would lead to lower default probability.I further empirically examine the relation between expected costs of financial distress and default probabilities based on theoretical analysis. I select seven corporate characteristic variables, which mainly determine financial distress costs, as proxy variables to expected costs of financial distress, in order to investigate information content of expected costs of financial distress in default predicting model. Univariate binary logistic regression model shows that many of proxy variables as expected costs of financial distress can provide significant default predicting power, in other words, they have relative information content in default predicting model. Multivariate binary logistic regression model shows all of the proxy variables as ECFD have incremental information content in default predicting model.The contributions of this dissertation to theory and practice are listed as the following: (1) Investors undervalued firms experiencing financial distress, burdened 14.3% cost of financial distress, therefore they should be cautious about firm's financial distress risk and their investment safety to avoid capital loss. (2) Because both corporate characteristics and corporate governance aspects are the determinants of FDC, securities supervisor institution should classify listed firms according to their corporate characteristics and governance background so as to enhance supervising efficiency. (3) Predictors such as accounting ratios, cash flow ratios, market return, and Variance of market return, only reflect ex post characteristics of firm's bad financial condition. They do not really foretell the incidence of financial distress. There doesn't exist ex ante cause-effect relation between those predictors and financial distress. This is one of reasons that financial researchers haven't achieved an (even approximately) agreement on predictors selecting for many years. Therefore it becomes a new research field in financial distress prediction that how to mine ex ante information to construct predictor variables. On the above background the information about ECFD is treated as predictors so that predicting accurancy will be exciting improved and the theories and techniques of default prediction are expected to be greatly enriched.The improvements and innovations of this dissertation can be concluded:(1) Define default as financial distress. The definition of financial distress in domestic study can be devided into three classes: Class one defines ST firm as financially-distressed firm; Class two is based on asset liquidity (current ratio); Class three identifies firm's financial conditions from the perspective of value-adding. I argue that according to the academic development of financial distress issues, there is a widely-accepted trend to define financial distress based on cash flows and debtor's interests. Moreover, the most commonly-occurred and representative event while in financial distress is default. Therefore I investigate financial distress cost issues in China's listed firms defining financial distress as default.(2) Measuring financial distress costs in China's listed companies based on both operating-performance perspective and equity-value perspective. I conduct a pioneering study on FDC in China's firms involving business performance and investors' interests. Operating-performance perspective measures operating losses of financially-distressed firm by firm itself; Equity-value perspective measures market losses of equity in the interests of investors.(3) Constructing a theoretical analysis framework of FDC determinants based on corporate characteristics and governance aspects. Extant studies on determinants of FDC are scattered in finance literatures. These studies' shortcomings are: firstly focusing only on specific corporate characteristic and failing to give a systematic and comprehensive examination; Secondly ignoring corporate governance effects. Referencing the extant sparse studies, this dissertation constructs a theoretical analysis framework of FDC determinants based on corporate characteristics and governance aspects, gives a systematic and comprehensive investigation on FDC determinants, and empirically examines these determinants.(4) Introducing proxy variables of ECFD to default predicting model. Widely-used predictors are accounting ratios, cash flow ratios, market return, and Variance of market return. These ratios only reflect ex post characteristics of firm's bad financial condition. They do not really foretell the incidence of financial distress. There doesn't exist ex ante cause-effect relation between those predictors and financial distress. Therefore it becomes a new research field in financial distress prediction that how to mine ex-ante information to construct predictor variables. This dissertation theoretically analyzes the relation among ECFD, financial policy, and default probabilities and introduces proxy variables of ECFD to default predicting model for the first time. This should be regarded as an innovation of FDC theory and default predicting techniques.