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 a...

a A Type I error occurs when a firm is predicted to be a bankrupt firm when it will not b A ...

Financial institutions utilize prediction models to predict bankruptcy. One such model is the Altman Z-score model, which

Question:

Financial institutions utilize prediction models to predict bankruptcy. One such model is the Altman Z-score model, which uses multiple corporate income and 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?

Balance Sheet
Balance sheet is a statement of the financial position of a business that list all the assets, liabilities, and owner’s equity and shareholder’s equity at a particular point of time. A balance sheet is also called as a “statement of financial...