The size and determinants of Indirect Financial Distress Costs Norhisam Bulot, Norhana Salamudin, Wan Mohd Yaseer Mohd Abdoh, Noor Hafizha Muhamad Yusuf , Hasyeilla Abd Mutallib. Abstract— the aim of this paper is to provide a quantitative estimate of the indirect financial distress costs. This paper focuses on the Malaysian trading and services sector and concentrates only on measuring the financial distress costs in terms of changes in operating performance and changes in capital values. This study will contribute to the existing literature by providing an alterantive proxy for indirect financial distress costs, and perhaps of the first paper to provide the quantitative estimate of the costs for Malaysia’s financially distressed firms. Findings from our study suggest that indirect costs exist, and are found to be between 3.1% to 21.39%. It also suggests that three variables; Tobin’s q, size and expected earnings growth are statistically significant at 0.01, 0.1 and 0.05 significance level. Keywords- financial distress; indirect costs; firm value; capital discount I. INTRODUCTION Indirect costs of financial distress, which is considered as opportunity costs (Warner, 1977), refer to the costs suffered by a firm as a consequence of its weakening financial position (Elali & Trainor, 2008) or a disruption of “business as usual” (Opler 1993). These costs may be viewed in two ways: (a) changes in the operational performance (E.I Altman, 1984; E.I. Altman & Hotchkiss, 2006; Bisogno & De Luca, 2012; Elali & Trainor, 2008; Lang, Poulsen, & Stulz, 1995; Sanz & Ayca, 2006; Scherr, 1983), and (b) changes in the value of the companies (Branch, 2002; Cutler & Summers, 1989; Singhal, 2003; Wijantini, 2007). Even though the theoretical debate about financial distress costs is entrenched in the study of capital structure (J. Pindado, Rodrigues, & De La Torre, 2008), the potential contribution of the study goes beyond capital structure literature. Financial distress costs were found to be a relevant factor for many financing decisions (Singhal & Zhu, 2013), such as in determining the optimal capital structure (Ahmed & Hisham, 2009), demand for conventional and Islamic insurance (M.A. Hamid, Osman, Ariffin, & Nordin, 2009), corporate hedging practices (Ertugrul, Sezer, & Sirmans, 2008; Judge, 2004), and trade receivables policy (Molina & Preve, 2009). This is further supported by the recent study conducted by (Nor, Ibrahim, Haron, Ibrahim, & Alias, 2012). Their study found that 88% of Malaysian managers indicate that the potential costs of bankruptcy or financial, is strongly influencing their decision in determining the appropriate amount of corporate debt for their firms. In addition, current literature related to the influencing factors affecting financial distress costs is very scattered. Several studies (see for example (Andrade & Kaplan, 1998; Julio Pindado & Rodrigues, 2005; Wijantini, 2007; Zhang & Gan, 2010)), have examined the variation in firms’ financial distress costs to determine which of the variables are significant in influencing the magnitude of financial distress costs. Despite the above mentioned importance of this topic, there are relatively few studies measuring the size and analysing the determinants of indirect costs (Tshitangano, 2010; White, 1983). One of the possible reasons for the lack of research on the indirect financial distress cost is due to its opportunity costs nature and the difficulty in specifying and empirically measuring such costs (E.I. Altman & Hotchkiss, 2006; Andrade & Kaplan, 1998; T. C. Opler, 1993). To the best of our knowledge, there was no study conducted for Malaysia’s financially distressed companies, which, contributing to the non-existence of financial distress cost data for Malaysia (Chin, 2005). Several authors have used other variables as a proxy for indirect financial distress costs. The examples are (M. A. Hamid, 2010; M.A. Hamid, et al., 2009), those who use working capital to total assets ratio, long term debt ratio and interest coverage ratio, and (Ameer, 2010) uses liquidity (ratio of quick assets to total current assets) as the proxy for the indirect financial distress costs. Our study is therefore, aiming to fill this gap. In this paper, we argue that the size and determinants of financial distress costs would be different due to its unique firm specific characteristics. The study on the magnitude and determinants of financial distress costs that is specific to Malaysia’s legal and listing requirement is very important because the existence and significance of the financial distress costs depend on the market setting (Warner, 1977), hence, empirical findings from other countries cannot be generalized to Malaysia. Furthermore, the robustness of the findings of the previous studies needs to be examined against evidences from other countries such as Malaysia. II. LITERATURE REVIEW A. Past Studies on Indirect Financial Distress Costs