Financial Distress and Value Premium using Altman Revised Z-score Model

Abstract

In the stock market, investors and value managers desire to be safe. Estimating equity returns and evaluating potential financial distress risk are essential for investment and trading decisions. The link between distress risk and stock return is controversial, and current literature yields contradicting results. A variety of models may be used to evaluate distress risk-return trade-offs. This paper employs a revised Altman Z-score to examine financial distress and value premiums. Using univariate and multivariate techniques, we examine firm- and industry-level portfolio returns, encompassing all Indian companies listed on the Bombay Stock Exchange (BSE). Results confirm the existence of the distress factor effect found in industry and firm-level portfolios. It shows that the distress risk factor significantly determines stock returns as an independent systematic risk factor. This result is consistently found in most industries. The study demonstrates the existence of a value premium in both distressed and safe zones. The study also used a multivariate GRS test and the Fama-Macbeth procedure to validate the reliability of the distress factor and pricing models. Results confirm that Altman model-based distress factor augmented models improve the performance of existing pricing models with higher reliability and accuracy.