Towards a Realistic Model of Corporate Debt Valuation

Abstract:     
Structural models of corporate debt valuation still commit significant errors. A recent paper (Ericsson and Reneby 2003) finds average errors that range between 3.8% and 7.7%. An aspect that has been overlooked in previous works is the irrealisticness of the assumptions considered, which tend to overestimate debt value. We develop a simplified debt valuation model that avoids the most frequent irrealistic features. Based on a simulated case, we applied our model and Ericsson and Reneby's one and compare the results. When valuing long term debt calibrated as low rated or speculative grade issues, our model, to a great extent, removes the average errors found by Ericsson and Reneby. In the case of high rated debt, the results may also be affected by the risk of 'asset substitution'. The irrealisticness of the structural models may be responsible for their persistent errors. This paper shows the need to reexamine them and to formulate more realistic assumptions.

Note: The Downloadable document is in Spanish.

Number of Pages in PDF File: 22

Keywords: Structural valuation models, contingent claim analysis, debt valuation, barrier options, asset substitution

JEL Classification: C69, G12, G32, G33

working papers series