| Whether or not financial distress costs are significant is an important issue in explaining capital structure decisions and in guiding managerial financing behavior. Financial distress costs include both direct and indirect costs. Many previous empirical studies have shown that the direct costs might be insignificant. Therefore, it is important to investigate the significance of the indirect costs of financial distress. The indirect costs represent the opportunity costs, mainly including abnormal loss of sales and profits and foregone investment opportunities. The reason for an abnormal sales drop in a financially distressed firm is that customers are hesitant or even reluctant to buy products or services from a firm which is in financial distress because they lose confidence in the firm's ability to provide good products or services and promised warranties.; We use the Z-score model of Altman (1968) to evaluate the degree of financial distress. The magnitudes of indirect costs for three different patterns of financially-distressed firms are examined. We find that the average annual profit loss across firms in trouble is 10.3% of the firm's total market value. This indicates that the indirect costs of financial distress are significant. The OLS regression tests show that the magnitude of abnormal sales loss is directly related to the extent of financial distress. We also investigate the effect of the overall economy on the indirect costs of corporate financial distress. By studying all financially-distressed firms in the 1983-91 period, it is found that the average sales loss is quite different from year to year. This suggests that with the same degree of financial distress in different economic states, the customer's response could be different.; The relations of leverage, firm size, and assets intangibility with sales performance are also examined. We find that for financially-distressed firms, both leverage and asset intangibility have negative effects on sales performance, while the size effect is inconclusive.; Also, our evidence shows that a financially-distressed firm typically cuts invested capital, or becomes more cautious about investment opportunities. High-leverage firms are relatively more aggressive in cutting invested capital when facing financial distress.; Finally, we carry-out an examination of the relation between Z-scores and stock returns. It is found that Z-scores are negatively related to stock returns. That is, stocks with high Z-scores (low risk) have low average returns while low-Z (high risk) stocks have high average returns. This evidence is consistent with existing asset pricing theory. We also find that small firms on average have higher stock returns than large firms. This finding supports the evidence of a size effect, documented by Banz (1981) and Reinganum (1981). |
