More than a Dummy: The Probability of Failure, Survival and Acquisition of Firms in Financial Distress

Abstract

We discuss three methodological issues concerning forecasts of the outcome of financial distress. First, we argue that rather than using a binary model the outcome of financial distress should be modeled using a multinomial specification that distinguishes between failure, survival as going concern, and acquisition. We also argue for a random rather than matched‐pair sampling technique to better reflect decision making reality. Finally, we investigate the value of using industry‐mean adjusted regressors. We find that the binary bankruptcy model is mis‐specified relative to the multinomial model, that the matched sampling technique overstates model accuracy and that industry specific intercepts have better explanatory power than industry‐adjusted regressors.