Two Paths to Financial Distress

Aharoni, Gil; Zeng, Qi; Brown, Christine A.

doi:10.2139/ssrn.1102093

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Two Paths to Financial Distress

44 Pages Posted: 7 Apr 2008 Last revised: 7 Apr 2008

See all articles by Gil Aharoni

Gil Aharoni

University of Melbourne; Financial Research Network (FIRN)

Qi Zeng

University of Melbourne - Department of Finance; Financial Research Network (FIRN)

Christine A. Brown

Department of Banking and Finance; Financial Research Network (FIRN)

Abstract

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

Aharoni, Gil and Zeng, Qi and Brown, Christine A., Two Paths to Financial Distress. Available at SSRN: https://ssrn.com/abstract=1102093 or http://dx.doi.org/10.2139/ssrn.1102093