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Risk-Shifting Behavior in Distressed Firms: Size Matters!

This study examines the empirical evidence of risk-shifting behavior in large and small distressed firms. The main contributions include the extension of a previous study and the use of a more rigorous method to measure asset return and volatility. The results suggest that the risk-shifting problem is more significant for small firms due to their agency problems.

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Risk-Shifting Behavior in Distressed Firms: Size Matters!

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  1. Comments onEmpirical Evidence of Risk Shifting Behavior in Large and Small Distressed Firms Yehning Chen National Taiwan University

  2. Main Contributions • An extension of Eisdorfer (2008) • Eisdorfer (2008): For distressed firms, • Volatility↑ → Gains from risk-taking↑→ Investment↑ • This effect is more significant when volatility is higher • Contribution 1: the above effects are significant only for small firms because their agency problems are more serious • Contributions 2: for measuring asset return and volatility, use Duan (1994, 2000) rather than Merton (1974)

  3. Comments • Very interesting idea: size (market capitalization) matters! Empirical results support the idea. Dependent: investment Dependent: ΔVolatility

  4. Comments Why does size matter? A puzzle! Is the risk-shifting problem more serious for small firms? Not necessarily. (complexity, bargaining power, …) Size is rarely used as a proxy for agency problems (Smaller → Adverse selection↑→ Risk shifting↑? ) Wild guess: size may be related to financial distress Given the same z-score: Larger firms → less likely to fail → less distressed → less likely to suffer risk-shifting 4

  5. Comments Using Duan (1994, 2000) to calculate asset return and volatility Plus: More rigorous conceptually Minus: Results less comparable to Eisdorfer (2008) How significant are the improvements? If claim the improvements are important → Need to show what differences it makes 5

  6. Comments Some minor points Style: too similar to Eisdorfer (2008) in format (tables, variables used, hypotheses, paragraphs…) Results in Table 7 (Cost of risk-shifting) are not significant Impact of investment on debt value is insignificant For small distressed firms, the overinvestment problem reduces value of debt only by 0.97% 6

  7. Comments Some minor points Results against the intuitions (1) z-score↑→ risk-shifting↓→ marginal return of investment↑ Table 3 finds the opposite results (for large firms) (2) Secured debt↑, convertible debt↑, or regulated industry → Risk-shifting problem should be less serious. Table 5 finds the opposite results 7

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