Financial Distress Identification: Application of Black-Scholes-Merton Model

Abstract

Financial distress is characterized by the inability to fulfill the financial obligations on time due to lack of liquidity. Corporate failures in the recent decade have highlighted that big sized companies are as vulnerable as the small and medium sized companies. In view of this rising awareness, it becomes imperative for the investors to consider the default probabilities of the companies before making any investment decisions. The paper aims to determine the probability of default among the NSE Nifty-500 companies for a period of ten years commencing from commencing from financial year 2007-08 to financial year 2016-17. The contingent claims model developed by Black-Scholes and extended by Merton has been applied to compute the probabilities of the select companies. R Studio (version 3.4.3) has been used to analyze the data. The results demonstrated that approximately 4 percent of the companies of the total companies were found to be financially distressed.

Keywords: Financial Distress, Black-Scholes-Merton Model, Probability of Default

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