7 THE INDIRECT COSTS OF FINANCIAL DISTRESS IN INDONESIA

Gadjah Mada International Journal of Business

May-August 2007, Vol. 9, No. 2, pp. 157-186

Wijantini

This paper presents quantitative estimates of the indirect cost of financial distress and its determinants. In order to measure the cost, this study estimates the annualized changes in industry-adjusted operation profit and sales from a year before the onset of distress to the resolution year. Using those approaches, the median of indirect financial distress cost is estimated between three and one percent annually. To the extent that the direct cost of financial distress reduces reported operating income, the estimated costs are overstated. The simple regressions analysis suggest that the indirect cost of financial distress significantly increases with size, leverage, number of creditors, and poor industry performance, but is not related to degree of bank loan reliance. The findings provide a weak support for the financial distress theory which suggests that conflicts of interest render the costs of financial distress.

Keywords: conflicts of interest; indirect cost of financial distress; industry factor

‘Acknowledgement:

This paper is based, in part, on my thesis completed at the University of Birmingham, UK. I am indebted to my supervisor, Dr. T.A Adedeji for his valuable comment

Introduction

The existence of total financial distress costs is a critical argument in corporate finance issues, such as optimal capital structure, firm valuation, and risk management. The initial work of Modigliani and Miller (1958, 1963) trigger seminal arguments on the importance of these costs. It is deeply embedded in most of the theoretical works of the authorities in this field (Kraus and Litzenberger 1973; Scott 1976; Castanias 1983; White 1983).

The objectives of this paper are, first, to estimate the indirect costs of financial distress in Indonesia. Capital structure theories give contradictory suggestions on whether the costs of financial distress are trivial (Modigliani and Miller 1958, 1963) or non-trivial (Myers and Majluf 1984). The estimates of indirect costs of financial distress obtained are used to determine which of these contradictory theoretical views is more relevant to Indonesia. Second, it purports to compare the estimates of indirect costs of financial distress obtained for Indonesia with similar estimates that were reported for the US. Estimates of the costs of financial distress that have been reported in the literature were obtained mainly with U.S. data. The results of comparison are beneficial for assessing the relevance of the estimates to a developing economy like Indonesia.

Finally, the other objective is to test the firm characteristics, which previous studies suggest to be the determinants of cross-sectional variation in the costs of financial distress in the U.S., on the firms in Indonesia, and to examine whether the impacts of the firm characteristics in Indonesia are similar to those reported in the U.S.

Brief Literature Review

Financial distress is a situation where firms cannot service their current debts. Financially distressed firms have to meet more costs than do normal firms. The costs may reduce firm value and conventionally consist of both direct and indirect costs. If firms at this state reorganize under court supervision and opt for liquidation, they may incur even higher directcosts than if they reorganize privately (Gilson, John, and Lang 1990). The values of their assets may go down progressively while waiting for liquidation. In addition, they will also indirectly be burdened by the costs imposed by customers, suppliers, and capital providers as a result of financially distressed condition and non-optimal managerial actions during the period of distress. Firms’ bad performance leads managers to lose time in formulating and communicating reorganization plans to their stakeholders. Hence, the total indirect costs of financial distress are potentially great and occur whether or not the firm actually defaults (Chen and Merville 1999).

Previous studies tried to find how high the costs of financial distress were, especially those related to the use of the costs in the capital structure theory.

Some empirical studies estimate the costs of financial distress as any reduction in the value of output in the real world relative to the hypothetical best world. Critiques appear to the measurement due to the lack of distinction between ex-ante and ex-post distress costs. The. importance of ex-ante distress cost should be addressed if it is to be applied in such a theory. Other studies divide the costs into three types, which are associated with the behavior of managers of failing firms who attempt to avoid or delay filing for bankruptcy. They can result from over-investment, under-investment, or the delay effect, all causing additional expenses. Financial distress also happens as a result of a mismatch between the currently available liquid assets of a firm and its current obligations under its financial contracts. To solve such mismatch problem, firms are supposed to restructure the assets and/or restructure the financing contracts. Restructuring the asset means that firms may convert illiquid assets to liquid ones, whereas restructuring the financial contracts relates to debt restructuring. In other words, the costs of financial distress are costs related to corporate liquidity policy and leverage policy. When the costs are high, firms may maintain a larger fraction of their assets as liquid assets and/or incur debt cautiously.

Economic researchers often find difficulty measuring the “pure” costs of financial distress. The difficulties come from an inability to distinguish whether the poor performance of a firm in financial distress is caused by the financial problem per se or is caused by factors which originally push the firm into financial distress, e.g., economic problems or fraud. Andrade and Kaplan (1998) offer the “pure” measurement of financial distress by using sample with positive operating income as evidence that the sample is not economically distressed firms, but firms which suffer from negative earnings after paying debt interest. The authors claim that their sample contains purely financially distressed firms, and for this reason they call their measurement ‘costs of financial distress’ . Measuring the costs of financial distress is done by comparing the estimated capital value of the distressed firm at the end of the year before the onset of distress to the capital value realized through the resolution of distress.

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