Mergers and bankruptcy costs

Abstract

This article compares the premerger and postmerger probability distributions of bankruptcy costs and derives the conditions under which the expected value of bankruptcy costs (BC) and the variability associated with them are lower after the merger. The criterion employed here is based on the mean-variance criterion. The article demonstrates that the expected value of BC will likely be lower after the merger and that both the coinsurance effect and the diversification effect will reduce the variability associated with the postmerger BC. The analysis implies that a change in BC can be a potential source of gain from the merger. This conclusion seems to be consistent with the empirical finding of a financial gain from mergers. In light of this conclusion, managers should, in negotiating the terms of the merger, assess the impact of the merger on BC, and the financial gain that can result from it, particularly for the purely conglomerate type of merger. Furthermore, there is increasing evidence indicating the relevance of BC to firm valuation. The relative impact of BC is even higher under the 1986 Income Tax Act, which implies that, given the statutory equality between the tax rates on ordinary income and capital gains, BC may have a greater role in balancing off the corporate tax advantage of debt financing. © 1989.