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Predicting probability of default of Indian corporate bonds: logistic and Zscore model
approaches
Arindam Bandyopadhyay
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To cite this document:
Arindam Bandyopadhyay, (2006),"Predicting probability of default of Indian corporate bonds: logistic and
Z#score model approaches", The Journal of Risk Finance, Vol. 7 Iss 3 pp. 255 - 272
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Logistics and
Z-score model
approaches
255
Abstract
Purpose This paper aims at developing an early warning signal model for predicting corporate
default in emerging market economy like India. At the same time, it also aims to present methods for
directly estimating corporate probability of default (PD) using financial as well as non-financial
variables.
Design/methodology/approach Multiple Discriminate Analysis (MAD) is used for developing
Z-score models for predicting corporate bond default in India. Logistic regression model is employed to
directly estimate the probability of default.
Findings The new Z-score model developed in this paper depicted not only a high classification
power on the estimated sample, but also exhibited a high predictive power in terms of its ability to
detect bad firms in the holdout sample. The model clearly outperforms the other two contesting models
comprising of Altmans original and emerging market set of ratios respectively in the Indian context.
In the logit analysis, the empirical results reveal that inclusion of financial and non-financial
parameters would be useful in more accurately describing default risk.
Originality/value Using the new Z-score model of this paper, banks, as well as investors in
emerging market like India can get early warning signals about the firms solvency status and might
reassess the magnitude of the default premium they require on low-grade securities. The default
probability estimate (PD) from the logistic analysis would help banks for estimation of credit risk
capital (CRC) and setting corporate pricing on a risk adjusted return basis.
Keywords India, Bonds, Modelling, Emerging markets
Paper type Research paper
Introduction
Corporate liabilities have default risk. There is always a chance that a corporate
borrower will not meet its contractual obligations and may renege from paying the
principal and the interest due. Even for the typical high-grade borrower, this risk is
there even though it may be small, perhaps 1/10 of 1 percent per year. Although these
risks do not seem large, they are in fact highly significant. They can even increase
quickly and with little warning. Further, the margins in corporate lending are very
tight, and even small miscalculations of default risks can undermine the profitability of
lending. But most importantly, many lenders are themselves borrowers, with high
levels of leverage. Unexpected realizations of default risk have destabilized,
decapitalized, and destroyed many internationally active lending institutions.
Following the release of the recent Reserve Bank of India (RBI) draft guidelines
(February 15, 2005) for the implementation of Basel II norms, the leading Indian banks
are preparing to design appropriate internal credit risk models. The major motive is the
incentive based approach for capital estimation for credit risk. In order to fetch the
early rewards of Basel II implementation, banks have to develop their own internal
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models for credit risk. Internal models offer an opportunity for a bank to measure and
price counter-party risk and systemize risks inherent in lending. Prediction of default
probability (PD) for each borrower or group of borrowers is the key input for the
estimation of regulatory capital as well as economic capital for banks. It is also equally
important for the banking industry and financial institutions to discriminate the good
borrowers (non-defaulting) from the bad borrowers (defaulting). This will not only help
them in taking lending decisions but also practicing better pricing strategies to cover
against the counter party risk. While, internationally, considerable research has been
made to predict corporate default, very few attempts have been done for Emerging
Market like India.
The purpose of this paper is to build a robust framework that enables banks and
financial institutions in emerging market economy like India to classify a firm in the
default or non-default category based on the information of its financial variables. This
kind of model can serve as a useful tool for quick evaluation of the corporate risk
profile. Second, it can also be used to track the firms to check for their default status
over time. As a result such model can help banks to get an early warning signal about
the default status of its corporate clients. In this paper, we estimate an MDA model to
predict corporate default using a balanced panel data of 104 Indian corporations for the
period of 1998 to 2003. The financial ratios and other basic information are collected
from the Centre for Monitoring Indian Economy (CMIE) Prowess database. This
database is similar to the Compustat database in the USA. However, as we have
mentioned earlier, it is not enough to know a qualitative differentiation of
counter-parties for properly evaluating credit risk. One has to go one step further
and differentiate quantitatively between different counter-parties. Accordingly, we
also estimate probability of default (PD) of each firm for the same corporate portfolio
through logistic regression. Here we also explore the role of non-financial factors in
predicting default. For this purpose, we empirically examine whether the combined use
of financial and non-financial factors lead to more accurate PD estimates.
The rest of the paper is structured as follows. In the next section we discuss about
the data, definitions and construction of variables and hypotheses. The third section
portrays the corporate bond default rates across different rating grades in India as well
as industry wise default rates. In the fourth section, we demonstrate the development
of the Z-score model for Indian corporations, main results, and the model validation.
The fifth section presents the results and methodology of logistic analysis to predict
corporate bond defaults. Here we also compare the significance of financial and
non-financial parameters in describing default risk. We have also tested the predictive
power of logistic model. The sixth section discusses the main conclusions.
Literature survey
In theory, corporate insolvency is indicated either by fall in the asset value or due to
liquidity shortage (i.e. falls in the ability to raise capital to finance project). Therefore,
we should expect that the ratios that reflect the cash flow structure and movement of
market value of firms asset to be different among defaulted and solvent firms (Wilcox,
1971; Scott, 1981). Several later studies incorporated these theoretically determined
financial characteristics in the explanation of corporate default. For example, Casey
and Bartczak (1985), Gentry et al. (1985) and Aziz et al. (1988) used cash flow variables
in their model in predicting corporate failure. Opler and Titman (1994) and Asquith
Logistics and
Z-score model
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257
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Industry dummy
Industry type
IND1
IND2
IND3
IND4
IND5
IND6
IND7
IND8
IND9
IND10
IND11
Total
Food products/sugar/tea/tobacco/beverages
Paper
Textile
Chemical
Machine/electrical/computers
Metal/non-metal
Auto/parts
Power
Diversified
Service
Other manufacturing
Number of firms
4
3
9
27
14
23
6
2
5
9
2
104
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Table I.
Industry categories of
sample companies
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In the logit analysis, we have included another financial variable: MVE_BVL the
equity market value over the book value of the liabilities proxy for the firms asset
values. It also measures the solidity of the firm. In calculating book value of total
liabilities, total net worth of the firm is subtracted from the total liability of the firm.
Hence, the BVL gives the book value of total outside liabilities of the firm.
All the six ratios represent either value or income of the firms with respect to total
assets. They are all hypothesized to be either positively related to solvency or
negatively related to the firms default probabilities.
Following non-financial variables are taken from the existing literature about
corporate solvency:
.
Age of the firm. Age of the company since incorporation. A relatively young firm
will probably show a low retained earnings/total assets (RE/TA) ratio because it
has not had time to build up its cumulative profits (Altman, 2000). Therefore, it
may be argued that the young firm is somewhat discriminated against in this
analysis, and its chance of being classified as bankrupt is relatively higher than
that of another older firm, ceteris paribus. But, this is precisely the situation in
the real world. The incidence of failure is much higher in a firms earlier years
[40-50 percent of all firms that fail do so in the first five years of their existence
(Dun and Bradstreet, annual statistics)]. The age effect is thus clear: young firms
are more likely to default. We take natural log of the number of years of the firm
since incorporation as measure of firm age.
.
Group ownership. Studies covering various countries have found that firms
associated with top business groups have greater stability in the cash flows and
show better productivity as well as risk sharing than unaffiliated firms
(Gangopadhyay et al., 2001). Together with the existence of mutual debt
guarantees through group affiliation, firms may reduce the possibility of
financial distress. Some studies delineating the effect of Indian business group
affiliation on firm sales have observed that top 50 business group firms have a
better reputation advantage in the product market and are likely to export more.
They are also on average spend more advertising, marketing, distribution and
research and development (R&D), and thus have larger amount of intangible
assets (Bandyopadhyay and Das, 2005). Accordingly, we can hypothesize that
top 50 business group firms are safer firms than their non-top 50 group
counterparts.
.
ISO Quality Certification (ISOD). This dummy is taken as a product market
signal about the firm that it maintains a quality management system and is
concerned with customer expectations and satisfactions. It has been empirically
observed that ISO certified firms are successful in the product market
(Bandyopadhyay and Das, 2005). Therefore we assume that possessing an ISO
certificate by a firm would reduce its chance of default.
Control variables-industry characteristics. The industry factors affect the firms
performance and therefore affect default as well. There are incidents of clustered
incidents of default. In order to capture the industry specific effects, our sample
firms have been classified into 11 industry dummies depending on its major
economic activity.
Logistics and
Z-score model
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261
Year 1
Year 2
AAA (%)
AA (%)
A (%)
BBB (%)
BB (%)
B (%)
C (%)
D (%)
AAA
AA
A
BBB
BB
B
C
D
97.08
2.54
0.00
0.00
0.00
0.00
0.00
0.00
2.92
87.57
4.35
0.74
0.83
0.00
0.00
0.00
0.00
7.93
79.97
5.90
0.00
0.00
0.00
0.31
0.00
1.05
9.14
67.53
1.65
7.41
2.33
0.31
0.00
0.60
3.48
14.76
57.02
0.00
0.00
0.92
0.00
0.15
0.44
2.21
4.13
55.56
0.00
0.00
0.00
0.00
0.73
3.69
7.44
7.41
51.16
0.00
0.00
0.15
1.89
5.17
28.93
29.63
46.51
98.46
Table II.
Average one year
transition matrix (years
1995-1996 to 2004-2005)
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Table III.
Industry wide average
PD for IG and NIG and
pooled, 1995-1996:
2004-2005
Industry
IG
NIG
Figures in percent
ALL
Auto/parts
Chemical
Diverse
Food products/sugar/tea/tobacco/beverages
Machine/electrical/computers
Metal/non-metal
Other manufacturing
Paper
Power
Service
Textile
1.79
0.88
3.70
1.37
2.75
3.11
0.00
0.00
0.00
0.22
1.52
16.67
32.00
18.75
55.56
37.14
35.48
0.00
33.33
0.00
27.78
40.00
2.87
3.98
7.14
7.41
7.51
6.60
0.00
5.66
0.00
1.25
5.44
Model
Z 2 1.689 2.436WK_TA
8.158RE_ TA 3.73PBIT_TA
0.037MVE_BVL 1.602
SALES_TA
Z 2 1.096 2.893WK_TA
1.197RE_TA 11.711PBIT _TA
0.042MVE_BVL
Z 2 3.337 0.736WK_TA
6.95CASHPROF _TA
0.864SOLVR
7.554OPPROF_TA
1.544SALES_TA
Model 2: re-worked
emerging market (1995)
Model 3: new Z-score model
Percent of correct
classification
(within sample)
Good
Bad
84
Logistics and
Z-score model
approaches
82
263
88.2
75.9
85.2
91
Table IV.
Three alternative
discriminant models for
Indian firms
Market Score Model (1995). Model 3 of Table V is ours. This new Z-score model
comprises of five ratios. Two of these ratios are same to those in Model 1 namely
working capital to total assets (WK_TA) and sales over total assets (SALES_TA).
Three new variables are cash profits to total assets (CASHPROF_TA), solvency ratio
(SOLVR), and operating profit over total assets (OPPROF_TA). The discussion on the
expected signs of these ratios has already been done in variable definitions section.
Although Model 1 and Model 2 exhibit a reasonable high degree of classification
power, Model 3 (which is ours) has the best ability to classify the current sample of
good and bad firms. However, the robustness of Model 3 needs to be established by a
set of diagnostic tests.
The first set of tests pertains to checking the difference of the means of the two
groups, both individually and also as a whole for the entire function. From Table VI,
the magnitude of the Wilks Lamda and F-statistic of the individual variables (used in
Model 3) suggests that given the data, the likelihood of the means of the solvent and
defaulted groups to be equal is highly unlikely. Hence, the null hypothesis of the
equality of means with respect the same variance co-variance matrix for both the
Solvent
(DEF 0)
Mean Std dev.
WK_TA
CASHPROF_TA
SOLVR
OPPROF_TA
SALES_TA
0.192
0.099
2.32
0.093
1.06
0.145
0.073
1.304
0.075
0.6
Defaulted
(DEF 1)
Mean Std dev.
20.068
20.027
1.27
20.032
0.57
0.33
0.092
0.37
0.084
0.33
0.796
0.633
0.763
0.622
0.796
153.3 *
347.33 *
185.26 *
363.56 *
152.81 *
Notes: Total number of observations: 624. F-statistic and Wilks Lambda are used for discriminating
the solvent group from the defaulted group. The higher value of F and lower value of Wilks Lambda
indicate greater chance for the null of equal means of the two groups to be rejected. * denotes
significant at 1 percent or better
Table V.
Group statistics
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groups is rejected at 1 per cent or better level of significance. The result also fits well
for the discriminant function as a whole. The overall chi-square of the discriminant
function is 388.8 with degrees of freedom 5 (with probability. x2 0:00) indicating a
very high overall significance of the model. Many other variables are also being tested;
however the variables used in the third model have the best combination with highest
level of discriminatory power.
The Z-score obtained in Model 3 may however suffer from the misclassification cost.
Misclassification may arise due to type I and type II errors. Type I error occurs when
the model incorrectly classifies a bad firm as good. Type II error arises when the
model identifies a good firm as bad. Obviously, type I error is more costly for bank
than the type II error. Therefore, it is necessary to estimate posterior probabilities to set
a benchmark to make a correct decision about the firms default status. For this, we
estimate two separate Fishers discriminant equations and for a firm:
Z solvent 26:812 2 1:72WK_TA 3:52CASHPROF_TA 3:016SOLVR
24:757OPPROF_TA 5:354SALES_TA
Table VI.
Classification power of
the model for the holdout
dample of 25 corporations
for the year 2004
Defaulted no.
correct (Type I)
Solvent no. correct
(Type II)
Model 1: re-worked
Altman (1968) (%)
80
84
92
88
84
96
Logistics and
Z-score model
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265
Model 1: re-worked
Altman (1968)
(%)
Model 2: re-worked
emerging market (1995)
(%)
Model 3: new
Z-score model
(%)
79
59
55
79
73
50
88
88
68
57
56
45
45
Notes: Using a holdout sample of 37 Indian corporate bonds defaulted between the year 1996-2005.
Also using 0 as the cutoff score
Table VII.
Relative comparison of
classification and
predictive accuracy of
three discriminant
models: early warning
signal (time dimension)
the long run predictive power of our model with Model 1 and Model 2. Our model (i.e.
Model 3) clearly out performs the other two models even if one goes back two years
prior to default (with 68 percent accuracy). Moreover, the type I accuracy rate of Model
3 is pretty high (88 percent) on data from one financial statement prior to default on
outstanding bonds.
266
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1e 2Z
Table VIII.
Relative comparison of
bankruptcy prediction
power of three
discriminant models:
early warning signal
(time dimension)
0
1
2
3
4
5
Model 1: re-worked
Altman (1968)
(%)
Model 3: new
Z-score model
(%)
94
95.3
82.5
73
62
55
95
95.3
85
73
68
56
97
96.3
87
78
73.3
68.1
Notes: Using a holdout sample of 148 Indian Manufacturing Firms reported bankrupted by Board for
Industrial and Financial Reconstruction (BIFR) of India in the year 2004. Also using 0 as the cut-off
score
Logistics and
Z-score model
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267
Mean
SOLVR
1.78
CASHPROF_TA
0.036
WK_TA
0.06
SALES_TA
0.81
MVE_BVL
1.303
ISOD
0.57
Dtop50grp
0.37
LN(AGE)
3.22
No. of observations 624
Mean
Mean
t-statistics
Std. dev. DEF 0 Std. dev. DEF 1 Std. dev. for difference
1.08
0.105
0.29
0.55
4.65
0.49
0.48
0.78
2.32
0.1
0.19
1.04
2.63
0.69
0.46
3.46
312
1.304
0.07
0.17
0.61
6.58
0.46
0.50
0.77
1.27
20.03
20.07
0.57
0.155
0.46
0.29
2.99
312
0.371
0.09
0.33
0.33
0.35
0.50
0.45
0.73
13.61 * * *
19.1 * * *
12.17 * * *
11.81 * * *
6.53 * * *
5.99 * * *
4.53 * * *
7.78 * * *
Table IX.
Descriptive statistics for
logit model: comparison
between defaulted group
and solvent group
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Table X.
Logit model: prediction of
default events with
different factor types
Variables
DEF
SOLVR
CASHPROF_TA
WK_TA
SALES_TA
MVE_BVL
ISOD
Dtop50grp
LN(AGE)
IND1
IND2
IND3
IND4
IND5
IND6
IND7
IND8
IND9
IND10
IND11
Intercept
Number of Obs.
LR x2 statistics
Prob.. x2
Pseudo R 2
Model 1
Model 2
Model 3
Coefficients
2 1.23 * * *
2 12.91 * * *
2 10.35 * * *
2 1.67 * * *
2 1.74 * * *
2 1.27 * * *
2 1.66 * *
2 1.114
Dropped
0.45
1.27
2.48 * *
0.86
0.46
Dropped
1.49
2 3.52 * * *
Dropped
11.46 * * *
518
492.93 (14)
0.00
0.70
Coefficients
2 1.47 * * *
2 13.49 * * *
2 9.02 * * *
2 1.79 * * *
2 1.56 * * *
2 1.88 * * *
2 0.805 * * *
Dropped
Dropped
2.37 * *
2.69 * * *
3.51 * * *
2.92 * * *
2.08
Dropped
1.57
2 1.89
Dropped
5.24 * * *
518
469.47 (14)
0.00
0.66
Coefficients
21.78 * * *
2 11.74 * * *
24.54 * * *
21.32 * * *
21.33 * * *
5.5 * * *
558
437.69 (5)
0.00
0.57
Notes: The dependent variable DEF is a default dummy; DEF=1, if the companys long term bond is
defaulted in any year between the year 1998 to 2003 and DEF =0, if there is no default. The model 1
and model 2 use all financial and non-financial factors. Model 3 uses only financial parameters. * * *
denotes significant at 5 percent or better; * * denotes significant at 5-10 percent
younger firms are more risky than the older firms. It is more likely that matured
firms have established a reputation with credit institutes and private investors that
alleviates the asymmetric information problems because an extended period of
scrutiny would permit a better understanding of the economic viability of the firm.
In the case of a liquidity crunch, an older firm could rely on such a relationship to
obtain additional lines of credit or favorable grace periods and can avoid a
corporate default event. On the other hand, young firms have less time to solidify
a relationship with its creditors and private investors hence increasing the chance
of financial distress during a credit crunch.
Similarly, the likelihood of default is less if the firm belongs to the top 50 business
group. Likewise, the ISO dummy (ISOD) has negative influence on the probability of
default (DEF), indicating that the firms that maintain a quality management system have
less chance of default. The industry dummies are significantly different from zero
suggesting that we cannot reject the presence of industry effects on firms default status.
Now, lets compare the diagnostic tests of these models. As reported in the lower panel
of Table X, Pseudo R 2 is highest (0.70) in Model 1 in comparison to Model 2 (0.66) and
Model 3 (0.57)[6]. The chi-square statistics is also highest in case of Model 1. We also
checked the predictive power of the logistic models by using ROC graphs in Figure 1 and
calculate the area under the ROC curve based on the model estimates by logit[7]. One can
clearly see from Figure 1 that Model 1 has the highest within sample prediction power of
97.2 percent in comparison to Model 2 and Model 3. Further, we have performed a
chi-squared test to summarize the predictive accuracy of these three models into a
summary statistic. The chi-squared test yielded a significance probability of 0.001
suggesting that there is a significant difference in the areas under the three ROC curves.
Hence, it is evident from our results that inclusion of non-financial factors along with the
financial factors improves the default-forecasting ability of the model. The results of
Model 1 indicate a strong relationship between default and the financial and non-financial
variables. The Model 1 can be directly used for finding PDs in credit-risk models[8].
Logistics and
Z-score model
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269
Figure 1.
Comparison of ROC
curves for three models
Predicted group
Original group
Defaulted
Solvent
Defaulted
47
(94%)
8
(16%)
Solvent
3
(6%)
42
(84%)
Total
50
(100%)
50
(100%)
Table XI.
Classification power of
the logistic Model 1 for
the holdout sample of the
years 2003 and 2004
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Conclusions
Using a sample of 104 listed corporations from CRISIL, we have developed a Z-score
model for Indian firms that can accurately predict bond default one year in advance.
The model not only has a high classification power within sample (91 percent), but also
exhibited a high predictive power in terms of its ability to detect bad firms in the
two-holdout samples (with 92 percent and 88 percent accuracy rates). Moreover, the
model also can predict corporate bankruptcy in two years prior to financial distress
with an accuracy rate of 97 percent and 96.3 percent respectively. The new Z-score
model of this paper outperforms the other two contesting models comprising of
Altman, 1968 and emerging market score 1995 set of ratios respectively. Using our
Z-score model, banks as well as investors can get early warning signals about the firm
and might reassess the magnitude of the default premium they require on low-grade
securities.
In the logit analysis, we link the firms performance with the macro economic
environment. The logit results show that PD is a decreasing function of cash profit
over total assets, working capital to assets, total sales relative to total assets, solidity,
solvency ratio, firm age, ISO certification and top 50 group affiliation. Further, industry
affiliation of a firm is also an important factor for explaining its default status and also
needs to be taken into account. From our empirical analysis we find that inclusion of
both financial and non-financial factors leads to more accurate default prediction than
the single use of accounting ratios.
Notes
1. CRISIL defines default as a credit event where the underlying corporate has missed
payments (a single days delay or a shortfall of even a single rupee) on a rated instrument in
terms of the promised repayment schedule. CRISILs rating does not factor in any post
default recovery.
2. A paired t-test on the mean asset difference between the two groups had shown statistically
insignificant results.
3. The probability of default (PD) per rating grade counts the average percentage of bond in
this rating grade in the course of one year.
4. It is empirically observed fact that the linear discriminant model has a higher holdout
sample predictive power compared to the quadratic discriminant model (Altman, 1993).
Moreover, the former is more amenable for interpretation compared to the latter.
5. A Wilcoxon rank-sum test showed that all the financial and non-financial parameters are
significantly better for solvent group (at 1 percent or better level) than the defaulted group.
6. Pseudo R 2 is a likelihood ratio index, which is analogous to the R 2 in a conventional
regression model. Here Pseudo R 2 1 2 Lmax =L0 , where L0 is the initial value of likelihood
function and Lmax is the highest value.
7. Receiver Operating Characteristic Curve (ROC) quantifies the accuracy of diagnostic tests to
discriminate between defaulted firms and solvent firms using each value of the logit score as
a possible cutoff point. The analysis uses the ROC curves of the sensitivity (percentage of
true defaulted outcomes correctly specified) vs. 1-specificity (percentage of false defaulted
outcomes correctly specified) of the diagnostic test. This calculates the area under the ROC
curve based on the model estimated by logistic regression predictions. The greater the area
under the ROC curve, the better the predictive power of the model. Therefore, a steeper curve
from the diagonal line indicates a more powerful model.
8. From Table results of Model 1, one can estimate the probability of default (PD) by using the
1
, zi a bX i , where a is the intercept and b represents
following equation: PDi 1exp2z
i
the parameters that may explain default incidents.
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bankruptcy, Journal of Finance, September, pp. 189-209.
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New York, NY.
Altman, E.I. (2000), Predicting financial distress of companies: revisiting the Z-score and ZETA
models, working paper, Stern School of Business, New York University, New York, NY.
Altman, E.I., Haldemann, R.G. and Narayan, P. (1977), ZETATM analysis: a new model to
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Corresponding author
Arindam Bandyopadhyay can be contacted at: arindam@nibmindia.org
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