Scandinavian Working Papers in Business Administration
SSE/EFI Working Paper Series in Business Administration,
Stockholm School of Economics
No 2006:5: Probabilistic Business Failure Prediction in Discounted Cash Flow Bond and Equity Valuation
Kenth Skogsvik ()
Additional contact information
Kenth Skogsvik: Center for Financial Analysis and Managerial Economics in Accounting, Postal: Stockholm School of Economics, P.O. Box 6501, SE-113 83 Stockholm, Sweden
Abstract: 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.
Keywords: Business failure prediction; DCF valuation; Bond valuation; Fundamental valuation; Residual income valuation
29 pages, May 1, 2006
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