Unraveling the Bankruptcy Risk‒Return Paradox across the Corporate Life Cycle

Abstract

Bankruptcy risk is a fundamental factor affecting the financial sustainability and smooth functioning of an enterprise. The corporate bankruptcy risk‒return association is well founded in the literature. However, there is a dearth of empirical research on how this association prevails at different stages of the corporate life cycle. The present study aims to investigate the bankruptcy‒risk relationship at different stages of corporate life cycle by employing Hierarchical Linear Mixed Model (HLMM) regression estimation on the data of listed non-financial Pakistani firms from 12 diverse industrial segments. We grouped the firms into introduction, growth, mature, shake-out, and decline stages of the life cycle using Dickinson’s model. Empirical results assert that corporate risk-taking at the introduction stage yields superior financial performance in the future, while risk at the growth stage positively contributes to a firm’s current performance. Moreover, because of risk-averse and non-diversified managerial behavior, bankruptcy risk at the mature stage is negatively associated with both current and future performance. Likewise, risk-taking at the decline stage has significant negative implications for firm performance as the managers of such firms undertake heavy investments in a turnaround attempt; however, owing to the risk-averse behavior, they may indulge in negative net present value (NPV) projects. The study findings imply that managers synchronize a firm’s risk exposure with the corresponding life cycle stage to avoid going bankrupt. Moreover, excessive risk-taking during the mature and decline stages can considerably harm the financial sustainability of an enterprise. Hence, investors should exercise a degree of caution when investing in highly indebted later-stage (mature and decline) firms. Overall, bankruptcy risk‒return resembles an inverted U-shaped relationship. Our results are robust and can apply to various econometric specifications.