Corporate Failure and Equity Valuation

This paper incorporates an annual probability of corporate failure into a standard equity valuation model, as an alternative or complementary correction for risk that improves in several ways over conventional risk premia or ad hoc adjustments to assumed growth rates. Though 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 premia than the traditional approach. Extensions of the model provide valuation under two growth regimes with stochastic transition time. The author is grateful for suggestions from Anil Kashyap and Fred Sterbenz. Sherrill Shaffer University of Wyoming Department 3985 1000 East University Ave. Laramie, WY 82071 [email protected] 307-766-2173 fax: 307-766-5090