An implementation of KMV-Merton Model in ranking the top nine Malaysian giant construction companies / Samshela Ismail ... [et al.]

In most cases, information on a company's revenue is used by decision-makers to determine which firm is the best to invest in. If, on the other hand, the value of the company's liabilities is high or almost equal to its revenue, the company's assets will not be sufficient to satisfy its liabilities. Then, the company is said to be in default. According to Zeitun, Tian, and Keen (2007), default can be understood as a firm that is unable to satisfy its obligations on the due date. Companies with high default risk may rank low among their competitors. The ranking is assumed important in an organization since it can be one of the benchmarks to the performance of companies. Thus, the use of KMV-Merton is introduced in this study as an indicator to indicate the companies' financial health. KMV-Merton model is a model developed by KMV Corporation based on the Black-Scholes-Merton option pricing theory. The KMV model is primarily used to estimate the likelihood of default of a firm. It is widely used due to its simple structure to be implemented and market based. Parameters involved to predict default are the firm's market value of the asset, book value of liabilities, volatility, and growth rate. However, there is a restriction where volatility, the market value of the asset, and the book value of liability cannot be equal to zero to predict the probability of default of firms. Zero values in those parameters may occur due to the static asset values in a certain period and the possibility of a firm having zero liability or asset. Based on Yusofand Jaffar (2012), if the market value of the asset is equal to zero and other parameters are greater than zero, then it is said that the firm has no chance for recovery and tends to go bankrupt. Contradicted to the case when the firm has zero liability, typically the firm is hard to be in a default situation. But if the firm’s assets remain unchanged, then no return and volatility are generated.