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Probabilistic Business Failure Prediction in Discounted Cash Flow Bond and Equity Valuation

Listed author(s):
  • Skogsvik, Kenth

    ()

    (Center for Financial Analysis and Managerial Economics in Accounting)

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    The purpose of the paper is to incorporate probabilistic business failure predictions in discounted cash flow (DCF) models for the valuation of company bonds and owners´ equity. The analysis shows that period-specific probabilities of business failure are instrumental to the assessment of expected values of cash flows in such models. Under somewhat restrictive conditions the failure risk can alternatively be accommodated through an adjustment of the discount rate, i.e. expected values of future cash flows conditioned on business survival can simply be discounted with such a discount rate. The result holds both in bond and equity DCF valuation modelling. In order for the accounting-based residual income valuation model to appropriately capture the failure risk, an additional accounting “failure loss recognition” principle as well as a novel term in the model specification have been identified.

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    Paper provided by Stockholm School of Economics in its series SSE/EFI Working Paper Series in Business Administration with number 2006:5.

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    Length: 29 pages
    Date of creation: 01 May 2006
    Handle: RePEc:hhb:hastba:2006_005
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