F ACTORS AFFECTING BANKRUPTCY ANNOUNCEMENT EFFECT

Following are factors considered and discussed by the literatures as influencing factors in the bankruptcy announcement effects.

1. Leverage

From the MM optimal capital structure theory, the cost of issuing debt is less than the cost of issuing equity. Moreover, issuing debt can signal the investors of the better credit-worthiness of the firm. However, as the debt ratio getting higher, the higher the bankruptcy cost the company will have. This is known as capital structure trade-off theory.

In the application of the bankruptcy announcement effect, leverage is of high correlation.

How leverage relates to the contagion effects?

Intuitively, the higher the leverage ratio, the more likely the competitor firms suffer from the contagious effect. The greater the leverage ratio is, the greater the increase in the present value of direct bankruptcy costs, thus the value of equity is more vulnerable to the changes in the total value of the firm. In short, if the bankruptcy filing conveys negative information about the industry, all else being equal, the greater the leverage is, the larger the percentage fall in equity of nonbankrupt firms. Lang and Stulz (1992) show a significant negative abnormal return in the portfolio of firms with leverage ratio above median, which implies that higher leverage increase the level of contagious effect.

How leverage related to competitive effects?

For given cash flows accruing to nonbankrupt firms, the competitive effects should be stronger in high leverage firms; however, the high leverage reduces firms’ ability to invest and hence prevent firms to gain the benefit of the bankrupt firms. Bolton and Scharfstein (1990) provide an explicit model to prove that low leverage firms can prey on a highly leveraged firm for its lack of flexibility to respond to changes in market conditions. As a consequence, leverage is ambiguous in the competitive effect. Thus, leverage magnifies the contagion effect rather than the competitive effect,

In Lang and Stulz (1992), taking the sample median as a critical point for the high and low leverage level, gets a coordinate result that the high-leverage samples’ abnormal stock return is significantly negative whereas the low-leverage is of positive but insignificant abnormal return. The afterwards research from Ferris, Jayaraman, and Makhija (1997) apply leverage only to the portfolio of competitive effect with companies survive more than three years after the bankruptcy announcement. But the competitive effect is still ambiguous in their test.

In short, leverage magnifies contagion but is ambiguous in competitive effect, hence leverage is used as measuring contagious effect in the bankruptcy announcement

literatures.

2. Degree of competition

According to literatures, the degree of competition affects the degree of competitive effect, but with no direct connections to contagious effect. Scholars argue that if the market is of imperfect competition, the bankrupt announcement of one firm is positive information for other firms in the industry for they will expect an increase in demand from an imperfectly elastic demand curve.

Lang and Stulz (1992) categorize the degree of competition with the Herfindahl ratio, which is the most traditional measure of concentration used in the industrial organization literature and is widely viewed as a proxy for imperfect competition. Since the competitive effect increases with the degree of concentration whereas the contagion effect is unrelated to concentration, as expected, Lang and Stulz (1992) get the result of significantly lower average abnormal return for the industry with lower Herfindahl index.

For industry concentration, Ferris, Jayaraman, and Makhija (1997) also use the median of Herfindahl Index as a measurement; however, they apply only to the sample of competitors that do not file for Chapter 11 in the next three years. Unfortunately, they have a result opposite to expected.

3. Interaction of leverage and the degree of competition

Lang and Stulz (1992) suggest that since the competitive effect increases the equity value of competitors whereas the contagion effect decreases it, one would expect industries with the strongest competitive effect to have significantly higher abnormal returns than industries of the strongest contagion effect. As a result, the competitive effect should be strongest for the sub-sample with low leverage and a low degree of competition, whereas the contagion effect should be highest for the sub-sample with high leverage and a high degree of competition and Lang and Stulz (1992) get a coincide result.

4. Similarity of cash flows

The contagion effect is expected to be larger for industries with similar investments to the bankrupt firm. Lang and Stulz (1992) use the correlation of returns between the competitors and the bankrupt firm as proxy and the sample median as the deviation point.

Although the industries with returns highly correlated with the bankrupt firm show significantly lower abnormal returns than the other industry portfolios, this measurement of similarity is highly negatively correlated with the Herfindahl index. Thus, it is still controversial to use the correlation of returns as representative factor for similarity of cash flows.

5. Separation of large and small firms

Lang and Stulz (1992) measure the bankruptcy announcement effect with only the bankruptcy liability more than 120 million, Ferris, Jayaraman, and Makhija (1997) extend the scope to all of the bankrupt files of the same period. Ferris, Jayaraman, and Makhija (1997) regard the NYSE/AMEX-listed bankrupt firms as large firm samples, and NASDAQ-listed bankrupt firms as small firm samples. Though the small firm samples react later than other categories, for the liquidity constraint, all of the categories show significant dominant contagious effects.