Web Extension 22A

Multiple Discriminant Analysis

What is MDA, and how can it be
used to predict bankruptcy?
 Multiple discriminant analysis (MDA) is a
statistical technique similar to multiple
regression.
 It identifies the characteristics of firms
that went bankrupt in the past.
 Then, data from any firm can be
entered into the model to assess the
likelihood of future bankruptcy.
MDA Illustration
 Assume you have the following 2009
data for 12 companies:
 Current ratio
 Debt ratio
 Six of the companies (marked by Xs)
went bankrupt in 2010 while six
(marked by dots) remained solvent.
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Current Ratio ■ Discriminant
■ Boundary
Solvent
Firms X
■
■
X
■ X Bankrupt
X Firms
■
X
X

■ = Solvent Debt Ratio

X = Bankrupt
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 The discriminant boundary, or Z line,
statistically separates the bankrupt and
solvent companies.
 Note that two companies have been
misclassified by the MDA program: One
bankrupt company falls on the solvent
(left) side and one solvent company
falls on the bankrupt (right) side.
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 Assume the equation for the boundary
line is
 Z = -2 + 1.5(Current ratio) - 5.0(Debt
ratio).
 Furthermore, if Z = -1 to +1, the future
of the company is uncertain. If Z >
1,bankruptcy is unlikely; if Z < -1,
bankruptcy is likely to occur.
Using MDA To Predict
Bankruptcy
 Suppose Firm S has CR = 4.0 and DR =
0.40. Then,
Z = -2 + 1.5(4.0) - 5.0(0.40) = +2.0,
and firm is unlikely to go bankrupt.
 Suppose Firm B has CR = 1.5 and DR = 0.75.
Then,
Z = -2 + 1.5(1.5) - 5.0(0.75) = -3.5,
and firm is likely to go bankrupt.
Some Final Points
 The most well-known bankruptcy
prediction model is Edward Altman’s
five factor model.
 Such models tend to work relatively
well, but only for the near term.
 The more similar the historical sample
to the firm being evaluated, the better
the prediction.