High corporate debt levels have caused concern about the potential economic costs of widespread failures in a recession. This project models the effects of bankruptcy and financial distress and provides empirical evidence on the costs of financial distress. Financial structure should affect the economic performance of distressed firms only if it is impossible to renegotiate debt contracts costlessly. This project explores renegotiation costs and their effect on the investment efficiency of troubled firms. The project analyzes the inefficiencies created by needing to reach agreement with several creditors rather than one. The role of reorganization law to promote investment efficiency is explored. The costs of financial distress are studied empirically. It is inherently difficult to distinguish financial distress from poor economic performance. The project attempts to do this by analyzing firm value response to adverse shocks as a function of leverage, controlling for the economic characteristics of the firm and industry. It studies the performance of firms in distressed industries in order to pick out the important sources of the indirect costs of financial distress as well as what determines if firms will use bankruptcy to restructure. This research deals with a timely and extremely important topic. Economic observers, policy makers and the press have expressed serious concerns that a recession will lead to wide-scale corporate bankruptcies which will impose large costs on the economy. Bank regulators are worried about the levels of risky debt taken by deposit-insured banks. The contribution of this project comes from incorporating into models of bankruptcy many of the important features of bankruptcy law that are ignored by existing models. The research will provide new evidence into the relationships between bankruptcy and the costs of financial distress.
