Empirical corporate probability of defaults in Kenya: Merton and modified KMV framework

Abstract

A firm's capital structure gives it an endogenous cause to default. Be that as it may, prior to default there is no way to precisely single out the firms that will default from those that will not. At best, we can only make a probabilistic assessment of the likelihood of default. Not to mention, depending on a firm 's choice of capital structure, the probability of default varies from a firm with a low financial leverage to one with a high financial leverage. This paper used the Merton Model to determine the probabilities of default in various sectors of Kenya and their relationship with varying debt tenors. The model generated high default probabilities for firms with a high leverage indicating that firms with a high leverage bear high financial risks. Furthermore, the default probabilities increased as the debt maturity increased signaling an increase in future uncertainty. Nonetheless, caution must be taken when interpreting the results since the Merton model carries assumptions that are at odds with reality. These assumptions can be relaxed and alternative modeling techniques can be employed in order to match real world situations. This can be a possible future research agenda.