Financial Distress and Corporate Performance

TL;DR: This paper found that firms in the top leverage decile in industries that experience output contractions see their sales decline by 26 percent more than do those in the bottom level of leverage, and a similar decline takes place in the market value of equity.

Abstract: This study finds that highly leveraged firms lose substantial market share to their more conservatively financed competitors in industry downturns. Specifically, firms in the top leverage decile in industries that experience output contractions see their sales decline by 26 percent more than do firms in the bottom leverage decile. A similar decline takes place in the market value of equity. These findings are consistent with the view that the indirect costs of financial distress are significant and positive. Consistent with the theory that firms with specialized products are especially vulnerable to financial distress, we find that highly leveraged firms that engage in research and development suffer the most in economically distressed periods. We also find that the adverse consequences of leverage are more pronounced in concentrated industries. FINANCIAL ECONOMISTS HAVE NOT reached a consensus on how financial distress affects corporate performance. Traditionally, the financial economics literature has portrayed financial distress as a costly event whose possibility is important in determining firms' optimal capital structures. Financial distress is seen as costly because it creates a tendency for firms to do things that are harmful to debtholders and nonfinancial stakeholders (i.e., customers, suppliers, and employees), impairing access to credit and raising costs of stakeholder relationships.1 In addition, financial distress can be costly if a firm's weakened condition induces an aggressive response by competitors seizing the opportunity to gain market share.2 More recent articles have