Financial institutions utilize prediction models to predict bankruptcy. One such model is the Altman Z- score model, which uses multiple corporate income and balance sheet values to mea-sure the financial health of a company. If the model predicts a low Z- score value, the firm is in financial stress and is predicted to go bankrupt within the next two years. If the model predicts a moderate or high Z- score value, the firm is financially healthy and is predicted to be a non- bankrupt firm (see pages. stern. nyu . edu/~ ealtman/ Zscores. pdf). This decision- making procedure can be expressed in the hypothesis- testing framework. The null hypothesis is that a firm is predicted to be a non- bankrupt firm. The alternative hypothesis is that the firm is predicted to be a bankrupt firm.
a. Explain the risks associated with committing a Type I error in this case.
b. Explain the risks associated with committing a Type II error in this case.
c. Which type of error do you think executives want to avoid? Explain.
d. How would changes in the model affect the probabilities of committing Type I and Type II errors?