SSE/EFI Working Paper Series in Business Administration
No 2006:5:
Probabilistic Business Failure Prediction in Discounted Cash Flow Bond and Equity Valuation
Kenth Skogsvik ()
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; (follow links to similar papers)
29 pages, May 1, 2006
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