i have this question in one of the past exams .
Discuss which model you would choose to calculate the probability of default of corporate
firms and give a rationale for including OR excluding the RE/TA and ME/TL from the model.
Model A: Constant WC/TA RE/TA EBIT/TA ME/TL S/TA Coefficient -5.14 1.41 -1.26 -9.46 -0.66 2.8 Standard error of the coefficient 0.32 1.42 0.38 3.68 0.34 0.72 p-value 0 0.32 0 0.01 0.05 0
Where: WC/TA is Working capital/Total assets RE/TA is Retained earnings/Total assets EBIT/TA is Earnings before interest and taxes/Total assets ME/TL is market value of equity/Total liabilities S/TA is Sales/Total assets The Pseudo-R2 for this model is 33% and the Likelihood Ratio (LR) test is 122, which is significant at the 1% level. The insignificant factors RE/TA and ME/TL are removed from Model A and the following logit model is produced. Model B: Constant WC/TA EBIT/TA S/TA Coefficient -4.69 -1.26 -4.73 -0.32 Standard error of the coefficient 0.26 0.36 4.93 0.25 p-value 0 0 0.34 0.2
The Pseudo-R2 for this model is 28% and the Likelihood Ratio (LR) test is 106, which is significant at the 1% level. A Likelihood Ratio (LR) test is calculated to compare the log-likelihood of the two models. The LR value is calculated as 15.5 with a p-value of 0.0%.