Bridge over ocean
1 January 2006 Financial Analysts Journal Volume 62, Issue 1

Corporate Failure and Equity Valuation

  1. Sherrill Shaffer

An important problem for portfolio managers is how to adjust the valuation of equity for the risk that the company may fail. Traditional adjustments seem ad hoc, and previous research on the topic has ignored the irreversible nature of failure. Here, a standard equity valuation model is extended to include a parsimonious but rigorous correction for a stationary annual probability of failure. Although the correction is nonlinear, it can be reduced to an equivalent function that enters the valuation equation in the traditional additive way. Empirical benchmarking suggests that, even without assuming risk-averse investors, this approach comes closer to predicting observed equity premiums than the traditional approach.

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