A re-examination of two major bankruptcy prediction models

This thesis examines two major bankruptcy prediction models existing in the literature: Altman's Z-score model and Ohlson's probabilistic model. The objective is to test whether the model parameters have changed from what they were when Altman and Ohlson originally estimated their models. Two reasons for expecting the parameter change are examined: (i) the change in U.S. bankruptcy law in the 1970s; and (ii) the increased use of financial leverage in the 1980s. The first portion of this thesis reviews the bankruptcy prediction literature and discusses the change in U.S. bankruptcy law and capital structure. The evidence presented in this study indicates that business failures have increased since 1980 and financial leverage follows an upward trend from the 1970s to the 1980s. The following four hypotheses associated with the original Altman and Ohlson models are developed: (1) the Type-I Error Hypothesis: the change in U.S. bankruptcy law in the 1970s increases the Type-I (classifying bankrupt firms as nonbankrupt)error rate; (2) the Type-II Error Hypothesis: the increased use ofleverage in the 1980s increases the Type-II (classifying nonbankrupt firms as bankrupt) error rate; (3) the Intercept Hypothesis: the change in the bankruptcy law in the 1970s will cause a significant increase in the intercept in Ohlson's model;and (4) the Leverage Hypothesis: the increased use of leverage in the 1980s will result in a significant decrease in the coefficient on TLTA (total liabilities /total assets) in Ohlson's model. The remaining portion of the thesis discusses sample design and tests the four hypotheses. Two samples from the 1980s are examined: a paired sample of 99 bankrupt and 99 nonbankrupt firms; and a sample of 99 bankrupt firms and 1,980 nonbankrupt firms. Using these samples, the predictive abilities of Altman's and Ohlson's models are examined and the models are re-estimated to test the four hypotheses. For Altman's model, the empirical results are consistent with the Type-II Error Hypothesis but inconsistent with the Type-I Error Hypothesis. For Ohlson's model, the results are also consistent with the Type-II Error Hypothesis but inconsistent with the Type-I Error Hypothesis. While the empirical results of re-estimating Ohlson's model support the Leverage Hypothesis, they do not support the Intercept Hypothesis.Business, Sauder School ofGraduat