1. Empirical Evidence of Risk Shifting Behavior in Large and Small Distressed Firms Chuang-Chang Chang Yu-Jen Hsiao Yu-Chih Lin Wei-Cheng Chen

2. Background Risk Shifting: a conflict of interest between equity holders and debt holders, is the most discussed agency problem in finance. Jensen and Meckling (1976) first introduced this concept. They argue that once a debt is in place, the value of firm’s equity is like an option due to the limited liabilities of the equity holders. There is very little empirical evidence of whether the problem actually exists. Until Eisdorfer (2008) provides empirical evidence indicating substantial risk-shifting behavior in financially distressed firms by studying the relation between investment and volatility.

3. Background Before Eisdorfer (2008), this relation is analyzed by using real option approach (Leahy and Whited(1996); Bulan(2003)) and provide the empirical evidences of the negative relation between investment and volatility. However, Eisdorfer (2008) argue that when a firm is in financial distress, volatility has two opposite effects on current investment-a negative effect of the option to delay investment and a positive effect of risk-shifting. According to the model implication of Eisdorfer (2008), the latter effect can dominate the former.

4. Background In related articles, Barnea et al. (1981) have argued that agency costs would be higher in smaller firms as a small business’s owner is likely to put his own and his venture’s interest first. Michaelas et al. (1999) they also argued that solutions to agency problems are relatively more expensive to small business, thus raising the cost of transactions between small business with their creditors, shareholders, and other stockholders.

5. Motivation Motivating from the argument of Barnea et al. (1981), we conjecture that the magnitude of risk-shifting for small financially distressed firms would be larger than those for large financially distressed firms are. Hence it is an interesting issue to examine whether the sizes of financially distressed firms affect the magnitude of risk-shifting behavior or not. Therefore, we divide the samples of financially distressed firms into two groups (small firms and large firms) according to firm’s size in this study (Loughran and Ritter(1995)). We then dig into the issue of risk-shifting behaviors for financially distressed firms.

6. Estimation Method Measuring Expected volatility  GARCH(1,1) (Engle(1982);Bollerslev(1986)) Measuring Investment intensity  Capital expenditure divided by property, plant and equipment at the beginning of the year. (Eisdorfer (2008) ) Estimating asset value and asset volatility  MLE (Duan(1994;2000)) Measuring extent of financial distress  Atlman’s Z-Score < 1.81 (Eisdorfer (2008) )

7. Data Our data are obtained from CRSP and COMPUSTAT. In addition, a firm must have sufficient data to compute asset value, asset volatility, investment intensity, expected total firm volatility and Z-score, or it will not be included in our sample. After including all firms traded on the NYSE, AMEX, and Nasdaq that satisfy these conditions, the final sample contains 33,393 firm-year observations over the period 1988 to 2006, representing 1,803 different firms.

8. Table I Descriptive Statistics

9. Hypotheses According to Michaelas et al. (1999)’s and Eisdorfer (2008) model’s implications, we argue that risk-shift behavior is only consistent for small distressed firms with the following two hypotheses: H1: The level of uncertainty has a weaker negative effect or even a positive effect on the investment of financially distressed firms. H2: The effect of investment on asset value in financially distressed firms diminishes as the level of uncertainty increase.

10. The results for testing Hypothesis 1 In other words, although results support the Hypothesis1 in all distressed firms when we use the expected market volatility and the expected industry volatility to be the measure of uncertainty with this study. However, comparing the results of Eisdorfer (2008), we find that the Hypothesis1 only holds in small distressed firms, but does not hold in large distressed firms.

11. The results for testing Hypothesis 2 The results of this tables show that the relation between investments and asset value of all distressed firms no difference with all healthy firms when the expected volatility is high. If we further examine the effect for large and small distressed firms during the expected industry volatility is high, we find that the investments of large distressed firms are more valuable during times of high uncertainty

12. The Effect of Investment on Firm-Specific Volatility For all distressed firms, positive changes in investment intensity in the previous year significantly increase firm-specific realized asset volatility in a given year. In addition, when we further examine this effect for large distressed firms, we find that positive changes in investment intensity in the previous year significantly decrease firm- specific realized asset volatility in a given year.

13. Estimating the Costs of Risk Shifting A more important issue is to measure the wealth transfer from debt holders to equity holders. To estimate the risk-shifting costs imposed on debt holders, we use Eisdorfer (2008) two-step procedure to do the estimation. In the first step, we estimate the sensitivity of debt value to investment of distressed firms for the subsample of high expected volatility by the slope coefficient of the following regression: Where is the firm’s debt value, measured by the difference between asset value (estimated by Duan(1994; 2000) method) and the market value of equity

14. In the second step we estimate the investment distortion in distressed firms for the subsample of high expected volatility. As reported in table II, there is a positive relation between expected volatility and investment of small distressed firms. Hence, the average of high uncertainty firm-specific investment intensity in small distressed firms (relative to small healthy firms) is expected to be higher than the average of entire firm-specific investment intensity in small distressed firms (relative to small healthy firms). This difference is referred as the overinvestment in the high uncertainty firm-specific investments in small distressed firms (relative to small healthy firms). The risk-shifting costs imposed on debt holders are therefore measured by multiplying the estimate of the overinvestment by the sensitivity of debt value to high uncertainty firm-specific investments: where and are the medians of investment intensity in distressed firms and healthy firms, respectively. Estimating the Costs of Risk Shifting

15. The results show that the value of debt in small distressed firms is reduced by approximately 0.97%, as the results of overinvestment in high uncertainty firm-specific investments by using MLE method proposed by Duan (1994; 2000).

16. Factors Affecting Risk-Shifting Behaviors If we further examine the effects of those factors on mitigating the relation between expected volatility and investment for small distressed firms. The factors including shorter maturity debt, and less growth options have significant effects on mitigating the relation between expected volatility and investment for small distressed firms.

17. Conclusion We find that only the small distressed firms consistent with these two hypotheses. This finding provides the evidence of risk-shifting behavior in small distressed firms, but risk-shifting behavior does not exist in large distressed firms. Furthermore, we also find that the changes in firm-specific investment intensity of small distressed firms in a given year significantly increase firm-specific realized asset volatility in the following year. In measuring a wealth transfer from debt holders to equity holders, we use the expected market volatility to identify high uncertainty firm-specific investments and estimate the investment distortion in these high uncertainty firm-specific investments in small distressed firms (relative to small healthy firms). The results show that the value of debt in small distressed firms is reduced by approximately 0.97%, as the results of overinvestment in high uncertainty firm-specific investments by using maximum likelihood estimation method proposed by Duan (1994; 2000). Finally, we examine the effects of several factors in reducing the incentive or limiting the ability of equity holders to increase the firm’s risk. The factors including shorter maturity debt, and less growth options have significant effects on mitigating the relation between expected volatility and investment for small distressed firms, when we use the expected market volatility to measure uncertainty.