Predicting corporate bankruptcy using the framework of Leland-Toft: evidence from U.S.

Abstract

In this paper, we evaluate an alternative approach for bankruptcy prediction that measures the financial healthiness of firms that have coupon-paying debts. The approach is based on the framework of Leland, H. and Toft, K.B. [Optimal capital structure, endogenous bankruptcy and the term structure of credit spreads. J. Financ., 1996, 51, 987–1019], which is an extension of a widely-used model; the Black–Scholes–Merton model. Using U.S. public firms between 1995 and 2014, we show that the Leland-Toft approach is more powerful than Black–Scholes–Merton in a variety of tests. Moreover, extending popular but also contemporary corporate bankruptcy models with the probability of bankruptcy derived from the Leland-Toft model, such as Altman, E. [Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. J. Financ., 1968, 23, 589–609], Ohlson, J.A. [Financial ratios and the probabilistic prediction of bankruptcy. J. Account. Res., 1980, 18, 109–131] and Campbell, J. Y., Hilscher, J. and Szilagyi, J. [In search of distress risk. J. Financ., 2008, 63, 2899–2939], yields models with improved performance. One of our tests, for example, shows that banks using these extended models, achieve superior economic performance relative to other banks. Our results are consistent under a comprehensive out-of-sample framework.