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

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 v...

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Bibliographic Details
Published inIDEAS Working Paper Series from RePEc
Main Author Skogsvik, Kenth
Format Paper
LanguageEnglish
Published St. Louis Federal Reserve Bank of St. Louis 01.01.2006
Subjects
Business failures
Cash flow forecasting
Discount rates
Discounted cash flow
Loss recognition
Valuation
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Summary: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.