CAPM based Quantification of Bankruptcy Risk: A Heuristic Approach

Abstract

This paper builds on Capital Asset Pricing Model (CAPM) and its ability to validate market and firm specific risk. The effort is aimed at ascertaining the role of bankruptcy risk in determining the cost of capital in firms and its impact on corporate valuation. We also attempt to replace and analyze disparity of systematic and unsystematic components of risk with bankruptcy and risk of future liquidity. A similar study has recently been carried out in Indian market by Shirur (2013) for checking the validity of beta and cumulative risk measurement for identifying the presence of bankruptcy risk. This research may be the first attempt at analyzing such semantics with data from Pakistan. Therefore, the current study attempts to investigate the role of bankruptcy risk in determining the cost of capital in corporate valuation and the need of segregating systematic risk and unsystematic risk into liquidity risk and bankruptcy risk. The findings of this study suggest that unsystematic risk shall be eluded while investing in a well-diversified portfolio, but after investing in a specific firm, the unsystematic risk needs to be incorporated in total corporate valuation.