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Capital Structure and the Prediction of Bankruptcy

by Suzan Hol of the Norwegian University of Science and Technology,
Sjur Westgaard of the Norwegian University of Science and Technology, and
Nico van der Wijst of the Norwegian University of Science and Technology

July 2002

Abstract: This paper addresses the theoretical foundations of bankruptcy prediction, using the neo-classical theory of capital structure as a starting point. The paper intends to demonstrate the feasibility of such an approach in a simple setting, i.e. by using a simple theoretical model and a limited empirical analysis. A model of optimal capital structure is constructed and rewritten as a model of default probability. Its empirical implications are derived and tested on a sample of Norwegian data. It is concluded that this approach clearly has its limitations, but also that it may be a valuable contribution compared to the multitude of theory-less empirical studies and a useful alternative to the default theory based on option pricing.

Keywords: Default Probabilities, Capital structure, Logistic regression.

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