Bankruptcy Prediction Models and the Cost of Debt

Posted: 21 May 2019 Last revised: 4 Sep 2019

See all articles by Sattar Mansi

Sattar Mansi

Virginia Tech

William F. Maxwell

Southern Methodist University (SMU) - Finance Department

Andrew (Jianzhong) Zhang

University of Nevada, Las Vegas - Department of Finance

Date Written: June 8, 2010

Abstract

Financial institutions and academic researchers utilize bankruptcy prediction models to assess distress risk. However, predicting default can be problematic since (i) few firms actually experience default in any one year, (ii) the lag between practical and actual default can vary significantly, (iii) firms can strategically default, (iv) firms can rework their obligations outside of bankruptcy, and (v) default frequency varies significantly over economic life cycles. Thus, relying on bankruptcy data alone to calibrate and validate these models can be problematic. We take a simpler approach by relying on the firm’s cost of debt as a market proxy for distress risk. We then assess the validity of four widely used bankruptcy models including two accounting-based models (Altman’s, 1968; Ohlson’s, 1980), one reduced form model (Campbell, Hilscher, and Szilagyi, 2010) and one structural distance to default model (Merton, 1974). We find dramatically different assessment of risk based on the models used. The Campbell, Hilscher, and Szilagyi (2010) model has the most explanatory power on the cost of debt followed by the Merton model. The accounting based approaches of Altman (1968)’s Z-Score and Ohlson (1980)’s O-Score are highly ineffective. We caution researchers when using Z- and O-Scores and recommend the use of Campbell, Hilscher, and Szilagyi model to measure distress risk. We also demonstrate the problems of not controlling for industry and time variation in any of these measures.

Keywords: Bankruptcy prediction models, cost of debt financing, distress risk

JEL Classification: C52, G13, G33, M41

Suggested Citation

Mansi, Sattar and Maxwell, William F. and Zhang, Andrew (Jianzhong), Bankruptcy Prediction Models and the Cost of Debt (June 8, 2010). Journal of Fixed Income, Forthcoming, https://doi.org/10.3905/jfi.2012.21.4.025, SMU Cox School of Business Research Paper No. 19-8, Available at SSRN: https://ssrn.com/abstract=1622407 or http://dx.doi.org/10.2139/ssrn.1622407

William F. Maxwell

Southern Methodist University (SMU) - Finance Department ( email )

United States

Andrew (Jianzhong) Zhang

University of Nevada, Las Vegas - Department of Finance ( email )

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Box 456008
Las Vegas, NV 89154-6008
United States

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