Abstract
Not every company justifies the confidence of its original investors placed in it. A free enterprise system is one of profit and loss. There is no guarantee that all capital will earn the “normal” rate of return. In a world of change, where sure knowledge of the future is lacking and decisions are made under conditions of more or less uncertainty, the operation of any business is a calculated risk. The data in Fig. 1 depicts the failure rate per 10,000 firms in the United States during the 1930–1998 period. The reader obviously notes the high level of business failures during the Great Depression. The reader may be surprised by the high level of failures during the 1980s, given the excellent stock market performance. Failures have risen substantially during the past 40 years and were very high during the 1990–1992 period. As noted in chapter “Financing Current Operations and Efficiency Ratio Analysis,” there was a deterioration in the Altman Z score, the bankruptcy prediction model, during the 1963–2003 period as a result of falling profit margins and sales efficiency. The large debt issuance of the 1975–2003 period, combined with high-interest rates during several years of the period, was no doubt an important factor in the rising failure rate. Buell and Schwartz (1981) modeled the failure rate in the United States during the 1950–1978 period as a function of the total debt to total assets ratio and the variation about the time trend of the level of employment. Buell and Schwartz reported the increases in the debt ratio were (highly) statistically associated with the failure rate, whereas the failure rate is negatively associated with employment. An economic downturn is associated with decreasing cash flows and lower operating cash flows of firms. Under an increase in financial leverage, a favorable turn in economic events can bring a firm high earnings; however, on the other hand, a recession in demand or a miscalculation of costs may entail substantial losses.
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Notes
- 1.
The Dun & Bradstreet (D&B) data is used in this chapter. However, the D&B data is not included in the economic report of the President after 1998. A second source of data is the American Bankruptcy Institute, ABI, which carries a 1980–2002 series on its website. The business bankruptcy filings on the ABI database for the 1998–2002 period are:
The decline in filings may be surprising given the stock market performance of the period. Source: www.abiworld.org.
- 2.
Sometimes a firm’s shares sell on the market consistently below their liquidation value. This indicates that the net liquidating asset value of the firm is greater than its value as a going concern. Of course, the inside holders or the management may strongly resist any proposal to liquidate.
- 3.
For example, the, Adams Express Company and Berkshire Hathaway are companies which have been turned from operating firms into investment companies.
- 4.
Furthermore, under the present tax loss carryforward provision, Company B would probably not have to pay any profits tax for some time.
- 5.
Failure, of course, should not be confused with an occasional slow payment on a bill or statement.
- 6.
A lawyer friend of one of the authors told us that in the world of business, it is not uncommon for a subordinated debt holder to threaten to hold up settlement. In such cases, it may be in the best interests to make a partial payment to the junior debtholders (claims) and allow settlement to proceed.
- 7.
Case v. Los Angeles Lumber Products Co., 308 U.S. 106 (1939)
- 8.
Warrants are options to purchase shares at a fixed price. If a warrant carries an option price of $15, and the shares have a market value of $10, the warrant has little intrinsic value. If the shares should rise above $15, however, the warrants are worth at least the difference between $15 and the share price. Actually, because of their speculative leverage, warrants tend to sell somewhat above their intrinsic value.
References
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Brealey, R. A., Myers, S. C., & Allen, F. (2006). Principles of Corporate Finanace. New York: Mcgraw-Hill/Irwin. 8th edition.
Buell, S. G., & Schwartz, E. (1981). Increasing leverage, potential failure rates, and possible impacts on the macro-economy. Oxford Economic Papers, 33, 442–458.
Guerard, J. B. Jr. & Schwartz, E. (2007). Quantitative Corporate Finance. New York: Kluwer Academic Press.
Schwartz, E. (1962). Corporate Finance, New York: St. Martin’s Press.
Van Home, J. C. (2000). Financial Management and Policy upper Saddle River, New Jersey: Prentice Hall.
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Guerard, J.B., Saxena, A., Gultekin, M. (2021). Corporate Restructing: Leveraged Buyouts, Liquidations, Failures, and Bankruptcies. In: Quantitative Corporate Finance. Springer, Cham. https://doi.org/10.1007/978-3-030-43547-9_19
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