Two Paths to Financial Distress
44 Pages Posted: 7 Apr 2008
One finding of recent empirical studies is that financially distressed stocks have large dispersion in their book to market value of equity (BM) ratios. In this paper we provide an explanation based entirely on rational decision making by investors. Our main argument is that the likelihood of a firm becoming either a low or high BM firm when it is distressed depends largely on the correlation between the cash flows of current and future projects. We provide a simple illustration of how this correlation affects firm characteristics. The associated predictions are consistent with the extant empirical evidence. We also derive several new predictions that are supported by our empirical tests.
Keywords: Financial Distress, Book to Market, Correlation
JEL Classification: G10, G12
Suggested Citation: Suggested Citation