A theoretical analysis of the stages and events experienced by financially distressed firms

Abstract

This paper analyses the events that start with financial distress and may eventually lead to the liquidation and/or abandonment of the assets of the firm. It develops a scheme describing the sequence of possible outcomes starting with financial distress based on the existing literature and taking into account the legal environment in terms of liability and priority rules and bankruptcy law. An analysis of the treatment of financial distress in the theoretical financial literature is also performed, showing that there is no consensus in the treatment of financial distress. The common case of assuming simultaneous default and bankruptcy is shown to lead to suboptimal bankruptcy. Other theoretical approaches are shown to address this problem in different ways such as separating default from bankruptcy or by including protective covenants. The case of separation between default from bankruptcy or liquidation highlights the importance of the interaction between the different options present in financial distress. The general case of exogenously determined default is shown to represent a special case that implies the existence of financial and credit constraints