Alternative Adaptations of Distressed Firms' Resources: The Valuation Roles of Book Value of Equity and Earnings

Abstract

I examine the relative valuation importance of book value of equity and net income of financially distressed firms that subsequently resolve their problem of financial difficulties through a merger or entering bankruptcy. Recent studies examine the complimentary roles of book value of equity and earnings in valuing equity. Book value of equity is more value-relevant for financially distressed (bankrupt) firms and earnings are more value-relevant for healthy (non-bankrupt) firms. However, these findings are consistent with two competing theories. I distinguish between these two theories and show that only book value of equity is significantly associated with market value for distressed firms that are bankruptcy candidates. For distressed firms that are merger candidates, I show that both book value of equity and net income are significantly associated with market value. The empirical evidence also provides a direct link between the alternative valuation roles of book value of equity and market value of equity. The results are robust after controlling for non-recurring items, industry, firm size and agency conflicts.

Keywords: Adaptation option; Liquidation option; Value relevance; Financial distress; Merger; Bankruptcy

JEL Classification: G12, G33, M41