IDEAS home Printed from https://ideas.repec.org/p/zbw/kbawps/32.html
   My bibliography  Save this paper

An alternative approach to estimation of the probability of default for commercial entities: The modified KMV Merton model

Author

Listed:
  • Njeru, Andrew Kioi

Abstract

We carry out an empirical test of KMV model for using private companies that are not listed on a stock exchange and in doing so, substitute book values for market values and fluctuations of bank account balances for volatility of stock prices. This study reveals a surprising effectiveness of the KMV model and its applicability for estimating probability of default for companies that are not listed on a stock exchange but only with a modification to adopt the actual observed asset growth of the company reported in the books of accounts instead of using the risk-free rate. The adoption of the bank balances as a proxy for the asset volatility has also performed well. One other finding is that the only three companies that had material exposure and defaulted did not have the up-to-date audited books of accounts. We could therefore not test the effectiveness of the KMV model because the three had no up to date books of accounts. This makes one to conclude that absence of audited book of accounts for a significant borrower is a major negative signal that a company is likely to default. This is more significant for larger companies who have a legal requirement to prepare the audited financial statements and the absence may be inferred to as a signal of inability to conclude the closure books of accounts with external auditors due to doubts about going concern.

Suggested Citation

  • Njeru, Andrew Kioi, 2019. "An alternative approach to estimation of the probability of default for commercial entities: The modified KMV Merton model," KBA Centre for Research on Financial Markets and Policy Working Paper Series 32, Kenya Bankers Association (KBA).
    • Handle: RePEc:zbw:kbawps:32
    as

    Download full text from publisher

    File URL: https://www.econstor.eu/bitstream/10419/249533/1/WPS-32.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Edward I. Altman, 1968. "Financial Ratios, Discriminant Analysis And The Prediction Of Corporate Bankruptcy," Journal of Finance, American Finance Association, vol. 23(4), pages 589-609, September.
    2. Edward I. Altman, 1968. "The Prediction Of Corporate Bankruptcy: A Discriminant Analysis," Journal of Finance, American Finance Association, vol. 23(1), pages 193-194, March.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Shaikh, Ibrahim A. & O'Brien, Jonathan Paul & Peters, Lois, 2018. "Inside directors and the underinvestment of financial slack towards R&D-intensity in high-technology firms," Journal of Business Research, Elsevier, vol. 82(C), pages 192-201.
    2. Mikel Bedayo & Raquel Vegas & Gabriel Jiménez & José-Luis Peydró, 2020. "Screening and Loan Origination Time: Lending Standards, Loan Defaults and Bank Failures," Working Papers 1215, Barcelona School of Economics.
    3. Ruey-Ching Hwang, 2013. "Forecasting credit ratings with the varying-coefficient model," Quantitative Finance, Taylor & Francis Journals, vol. 13(12), pages 1947-1965, December.
    4. Giordani, Paolo & Jacobson, Tor & Schedvin, Erik von & Villani, Mattias, 2014. "Taking the Twists into Account: Predicting Firm Bankruptcy Risk with Splines of Financial Ratios," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 49(4), pages 1071-1099, August.
    5. Li, Chunyu & Lou, Chenxin & Luo, Dan & Xing, Kai, 2021. "Chinese corporate distress prediction using LASSO: The role of earnings management," International Review of Financial Analysis, Elsevier, vol. 76(C).
    6. Suzan Hol, 2006. "The influence of the business cycle on bankruptcy probability," Discussion Papers 466, Statistics Norway, Research Department.
    7. Pavol Durana & Lucia Michalkova & Andrej Privara & Josef Marousek & Milos Tumpach, 2021. "Does the life cycle affect earnings management and bankruptcy?," Oeconomia Copernicana, Institute of Economic Research, vol. 12(2), pages 425-461, June.
    8. Dinh, K. & Kleimeier, S., 2006. "Credit scoring for Vietnam's retail banking market : implementation and implications for transactional versus relationship lending," Research Memorandum 012, Maastricht University, Maastricht Research School of Economics of Technology and Organization (METEOR).
    9. Elizaveta Danilova & Evgeny Rumyantsev & Ivan Shevchuk, 2018. "Review of the Bank of Russia – IMF Workshop 'Recent Developments in Macroprudential Stress Testing'," Russian Journal of Money and Finance, Bank of Russia, vol. 77(4), pages 60-83, December.
    10. Alderson, Michael J. & Betker, Brian L. & Halford, Joseph T., 2021. "Fictitious dividend cuts in the CRSP data," Journal of Corporate Finance, Elsevier, vol. 71(C).
    11. Pesaran, M. Hashem & Schuermann, Til & Treutler, Bjorn-Jakob & Weiner, Scott M., 2006. "Macroeconomic Dynamics and Credit Risk: A Global Perspective," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1211-1261, August.
    12. Nabeel Al-Milli & Amjad Hudaib & Nadim Obeid, 2021. "Population Diversity Control of Genetic Algorithm Using a Novel Injection Method for Bankruptcy Prediction Problem," Mathematics, MDPI, vol. 9(8), pages 1-18, April.
    13. Sandrine Lardic & Claire Gauthier, 2003. "Un modèle multifactoriel des spreads de crédit : estimation sur panels complets et incomplets," Économie et Prévision, Programme National Persée, vol. 159(3), pages 53-69.
    14. Hu, Xiaolu & Shi, Jing & Wang, Lafang & Yu, Jing, 2020. "Foreign ownership in Chinese credit ratings industry: Information revelation or certification?," Journal of Banking & Finance, Elsevier, vol. 118(C).
    15. Lauren Stagnol, 2015. "Designing a corporate bond index on solvency criteria," EconomiX Working Papers 2015-39, University of Paris Nanterre, EconomiX.
    16. Nadiah Amirah Nor Azhari & Suhaily Hasnan & Zuraidah Mohd Sanusi, 2020. "The Relationships Between Managerial Overconfidence, Audit Committee, CEO Duality and Audit Quality and Accounting Misstatements," International Journal of Financial Research, International Journal of Financial Research, Sciedu Press, vol. 11(3), pages 18-30, June.
    17. Nagar, Neerav & Sen, Kaustav, 2016. "Earnings management in India: Managers’ fixation on operating profits," Journal of International Accounting, Auditing and Taxation, Elsevier, vol. 26(C), pages 1-12.
    18. Lin, Hsiou-Wei William & Lo, Huai-Chun & Wu, Ruei-Shian, 2016. "Modeling default prediction with earnings management," Pacific-Basin Finance Journal, Elsevier, vol. 40(PB), pages 306-322.
    19. Fabio Panetta & Fabiano Schivardi & Matthew Shum, 2009. "Do Mergers Improve Information? Evidence from the Loan Market," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(4), pages 673-709, June.
    20. Jiang, Jie & Hou, Jack & Wang, Cangyu & Liu, HaiYue, 2021. "COVID-19 impact on firm investment—Evidence from Chinese publicly listed firms," Journal of Asian Economics, Elsevier, vol. 75(C).

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:zbw:kbawps:32. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ZBW - Leibniz Information Centre for Economics (email available below). General contact details of provider: https://www.kba.co.ke/about_research_center.php .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.