European Journal of Operational Research 139 (2002) 371389 www.elsevier.

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O.R. Applications

Multi-group discrimination using multi-criteria analysis: Illustrations from the eld of nance q
Constantin Zopounidis *, Michael Doumpos
Financial Engineering Laboratory, Department of Production Engineering and Management, Technical University of Crete, University Campus, Chania 73100, Greece Received 28 February 2001; accepted 2 May 2001

Abstract The primary objective in the discrimination problem is to assign a set of alternatives into predened classes. During the last two decades several new approaches, such as mathematical programming, neural networks, machine learning, rough sets, multi-criteria decision aid (MCDA), etc., have been proposed to overcome the shortcomings of traditional, statistical and econometric techniques that have dominated this eld since the 1930s. This paper focuses on the MCDA approach. A new method to achieve multi-group discrimination based on an iterative binary segmentation procedure is proposed. Five real world applications from the eld of nance (credit cards assessment, country risk evaluation, credit risk assessment, corporate acquisitions, business failure prediction) are used to illustrate the eciency of the proposed method as opposed to discriminant analysis. 2002 Elsevier Science B.V. All rights reserved.
Keywords: Discrimination; Multicriteria decision aid; Preference disaggregation; Financial decision making

1. Introduction Decision making problems may involve the choice of an alternative solution, the ranking of the alternatives from the best to the worst ones or the discrimination between the alternatives belonging into dierent classes (groups). The former two problematics (choice, ranking) are based on

q A rst draft of this paper has been presented at the EURO XVI Conference, Brussels, July 1215, 1998. * Corresponding author. Tel.: +30-821-37236; fax: +30-82169410. E-mail address: kostas@ergasya.tuc.gr (C. Zopounidis).

relative judgments among the considered alternatives (i.e., each alternative is compared to the others to determine a preference relation), while discrimination involves absolute judgments. In this case, a discrimination rule must be determined to decide upon the classication of the alternatives on the basis of their comparison with some reference points corresponding to each class (i.e., proles, thresholds). Discrimination problems are very common in several elds of nance, including bankruptcy prediction, credit granting, corporate mergers and acquisitions, country risk evaluation, venture capital investments, portfolio selection and management, etc. In all these cases, performing relative

0377-2217/02/$ - see front matter 2002 Elsevier Science B.V. All rights reserved. PII: S 0 3 7 7 - 2 2 1 7 ( 0 1 ) 0 0 3 6 0 - 5

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judgments to determine the competitive level among the considered alternatives (rms, stocks, countries, venture capital investments, etc.) provides little information to the decision maker. For instance, in credit granting, the primary interest of a credit analyst is to discriminate among viable and non-viable rms. Concluding that a rm a is better than a rm b is of no use to the credit analyst, unless a specic conclusion on their viability is determined. The major practical interest of the discrimination problem has motivated researchers in proposing an arsenal of methods for studying it, in order to develop discrimination models that could accurately discriminate among the considered groups of alternatives. Multivariate statistical and econometric techniques such as discriminant analysis, logit analysis and probit analysis have dominated this eld at least until the 1980s. Their restrictions (see Altman et al. (1981), for a detailed discussion), along with the advances in other elds such as operations research and articial intelligence, led many researchers to explore the development of alternative discrimination approaches. Among the attempts made, a signicant part is devoted on the development of multicriteria decision aid (MCDA) discrimination methods. The MCDA has gained signicant recognition among operations researchers/management scientists as a powerful approach to analyze complex decision problems that involve multiple and usually conicting criteria and/or goals. The rst MCDA discrimination methods appeared in the late 1970s and the early 1980s with the works of Roy and Moscarola (1977) and Roy (1981) on the outranking relations approach for trichotomic discrimination problems, the works of Freed and Glover (1981a,b) on goal programming techniques, the work of Devaud et al. (1980) on the preference disaggregation approach, and the work of Pawlak (1982) on the rough set theory. Since then, the MCDA discrimination methods based on goal programming have evolved signicantly (see Stam (1997), for a comprehensive review), while the major thrust on the development of outranking relations discrimination techniques became from the work of Yu (1992) on the ELECTRE TRI method. Rough sets have also attracted the inter-

est of many MCDA researchers, and signicant advances have been made both on extending their preference modeling capabilities, as well as on their extension to study choice and ranking problems (see Pawlak and Slowinski (1994), for a review of the rough sets approach to the multiattribute sorting problem). Preference disaggregation analysis (Pardalos et al., 1995) provides an alternative multi-criteria approach to study discrimination problems. In its most common form, preference disaggregation analysis leads to the development of additive utility functions that serve as discrimination models used to decide upon the classication of the alternatives. In contrast to the goal programming approach, the developed additive utility functions are piecewise linear, thus providing a theoretical advantage in cases where the considered classes are not linearly separable (most goal programming formulations lead to the development of a linear discriminant function). Furthermore, the general approach of preference disaggregation analysis provides a exible framework for supporting the parameter estimation process of alternate MCDA methods such as the ones based on the outranking relation concept. The ELECTRE TRI method (a representative example of MCDA sorting method based on the outranking relations approach) requires the specication of a signicant amount of parameters such as criterias weights, dierence/ indierence/veto thresholds, the proles that distinguish the classes, etc. Recently Mousseau and Slowinski have proposed a methodology that implements the preference disaggregation philosophy to estimate the parameters used to construct an outranking relation through the ELECTRE TRI method. A similar approach has also been used by Kiss et al. (1994) for the ELECTRE II method. Generally, the use of a reference set of alternatives for parameter estimation, serves as an example of how the decision maker evaluates the alternatives under consideration in order to achieve their classication. Then, using mathematical programming techniques it is possible to estimate an additive utility function (or any other form of aggregation model) that minimizes the dierences between the decision makers classication on the reference set that is employed, and

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the estimated classication that is determined through the developed utility function. On the basis of the estimated decision model developed through this approach, an interactive dialog with the decision maker can then be established in order to further calibrate the model so as it represents the decision makers preferential system as consistently as possible. Recent works towards this research direction have been presented by JacquetLagrze (1995) and Zopounidis and Doumpos e (1998, 1999). Following the methodological framework of preference disaggregation analysis in MCDA, this paper presents a new method for multigroup discrimination problems. The method employs an iterative binary segmentation procedure to determine the class in which the alternatives belong. The method leads to the development of a set of additive utility functions, which are used to decide upon the classication of each alternative into a specic group. The additive utility functions are estimated through the solution of three mathematical programming formulations (two linear and one mixed-integer), in order to achieve the optimal discrimination both in terms of the number of misclassications, as well as in terms of the clarity (sharpness) of the discrimination. The rest of the paper is organized as follows. Section 2 presents in detail the basic characteristics, the features, the mathematical formulation, as well as the operation of the proposed method. The performance of the method is illustrated in Section 3 through ve applications in the eld of nancial management (credit cards assessment, country risk, credit risk evaluation, company mergers and acquisitions, and business failure prediction). Finally, Section 4 concludes the paper and outlines some possible future research directions.

the method may be summarized in the following two aspects: 1. It distinguishes the groups progressively, starting by discriminating the rst group (best alternatives) from all the others, and then proceeding to the discrimination among the alternatives belonging into the other groups. This binary segmentation procedure leads to the development of a decision tree that facilitates the decision regarding the classication of the alternatives. 2. It incorporates three dierent measures of the obtained discrimination quality. Initially, the minimization of the classication error is performed, in distance terms (L1 -norm). In a second step the method seeks whether a rearrangement of the classication errors that occur after the rst step is possible so that the total number of misclassications is minimized (L0 -norm). Finally, the maximization of the clarity (sharpness) of the discrimination obtained after the previous two steps is sought (L1 -norm). The subsequent sections describe in more details both the iterative binary segmentation procedure, and the mathematical programming formulations that are employed to develop the optimal discrimination model, where the term optimal refers to the total number of misclassications and to the clarity of the obtained discrimination. 2.1. Model formulation Let A fa1 ; a2 ; . . . ; an g be a set of n alternatives to be classied into q ordered classes C1 1 C2 1 1 Cq (C1 is preferred to C2 , C2 is preferred to C3 , etc.). Each alternative is described (evaluated) along a set of m evaluation criteria G fg1 ; g2 ; . . . ; gm g. The set G may include criteria of both increasing and decreasing preference. Without loss of generality, the subsequent discussion of the method will be focused on increasing preference criteria (decreasing preference criteria can be treated as increasing preference criteria, though a simple sign reversal transformation). The evaluation of an alternative a on criterion gi is denoted as gi a. According to the set A of alternatives, for each evaluation T criterion the set Vi a gi a fgi1 ; gi2 ; . . . ; gipi g is

2. The multi-group iterative binary segmentation procedure The proposed multiple criteria discrimination method is a non-parametric approach to study discriminant problems involving two or more ordered groups of alternatives. The major features of

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m X i1

dened, consisting of the pi dierent values of criterion gi (gi1 is the smallest value and gipi is the largest one). 2.2. The segmentation process The method proceeds progressively in the classication of the alternatives into the predened classes, starting by discriminating among the alternatives of the rst class C1 (best alternatives) and the alternatives belonging into the other classes. The alternatives that are found to belong into class C1 (correctly or incorrectly) are excluded from further consideration. In a second stage the objective is to discriminate among the alternatives of the second class C2 and the alternatives belonging into the remaining classes (C3 ; C4 ; . . .) Once again, all the alternatives that are found to belong into class C2 (correctly or incorrectly) are excluded from further consideration, and the same procedure continues until all alternatives have been classied into the predened classes. Throughout this iterative binary segmentation procedure, it is assumed that the decision makers preferences are monotone functions (increasing or decreasing) on the criterias scale. This assumption implies that as the evaluation of an alternative on a criterion increases, the decision regarding the classication of this alternative into a higher (better) class is more favorable to the decision regarding the classication of the alternative into a lower (worse) class. According to this assumption the following general classication rule is imposed: The classication of an alternative a into one of the predened classes C1 1 C2 1 1 Cq should be determined on the basis of the utilities of the corresponding alternative decisions, that is, on the comparison of the utility of classifying a into C1 as opposed to the utility of classifying a into C2 , etc. The classication decision with the maximum utility is chosen. The utility of a decision concerning the classication of an alternative a into group Ck can be expressed in the form of an additive utility function:

U Ck a

uCk gi a 2 0; 1; i

denotes the marginal (partial) where utility of the decision concerning the classication of an alternative a into group Ck according to criterion gi . This utility function does not indicate the overall performance of an alternative with regard to all the evaluation criteria; it rather serves as a measure of the conditional similarity of an alternative a to the characteristics of the category Ck , when the choice among Ck and all the lower (worse) categories Ck1 ; . . . ; Cq is considered. The aforementioned assumption regarding the monotonicity of the decision makers preferences on the criteria scale implies that uCk gi will be an i increasing function on the criterions scale, while on the other hand the marginal utility of a decision concerning the classication of an alternative, according to criterion gi , into a group lower than Ck (denoted as u$Ck gi ) will be a decreasing function i on the criterions scale (Fig. 1). Denoting as gij and gij1 two consecutive values of criterion gi (gij1 > gij , 8gi 2 G), the monotonicity of the marginal utilities, can be expressed in mathematical terms through the following constraints: uCk gi1 0; i u$Ck gipi 0; i uCk gij1 > uCk gij ; i i u$Ck gij1 < u$Ck gij : i i These constraints may be simplied by introducing a small positive constant t as the lower bound of the dierence of the marginal utilities among the consecutive values gij and gij1 : wCk uCk gij1 uCk gij ; i i ij;j1 w$Ck u$Ck gij u$Ck gij1 ; i i ij;j1 wCk P t ij;j1 and w$Ck P t ij;j1 8gi 2 G:

uCk gi a i

Thus, the marginal utility of criterion gi at point gij can be calculated through the following formulas:

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Fig. 1. Marginal utility functions.

j1 X l1 pi 1 X lj

uCk gij i

wCk il;l1

and

u$Ck gij i

w$Ck : il;l1

Clearly, at each stage k of the binary segmentation procedure k 1; 2; . . . ; q 1, two utility functions are constructed. The rst one corresponds to the utility of a decision concerning the classication of an alternative a into class Ck (denoted as U Ck a), while the second one corresponds to the utility of a decision concerning the non-classication of an alternative a into class Ck , (denoted as U $Ck a). Based on these two utility functions the aforementioned general classication rule can be expressed as follows: if U Ck a > U $Ck a; then a 2 Ck ; if U Ck a < U $Ck a; then a 62 Ck : 1

performance of the alternatives on each of the evaluation criterion aects their classication. Following the classication rule (1), the overall iterative binary segmentation procedure is presented in Fig. 2. 2.3. Estimation of utility functions To achieve the classication of the alternatives into q classes using the aforementioned iterative binary segmentation procedure, 2q 1 additive utility functions must be estimated. The estimation of these utility functions is accomplished through mathematical programming techniques. More specically, at each stage of the binary segmentation procedure, two linear programs and one mixed-integer program are solved to estimate optimally the two additive utility functions. 2.3.1. LP1: Minimizing the overall classication error According to the classication rule (1), to achieve the correct classication of two alternatives a 2 Ck and b 62 Ck at stage k (cf. Fig. 2), the estimated utility functions should satisfy the following constraints: U Ck a > U $Ck a and U Ck b < U $Ck b:

The case where U Ck a U $Ck a can only appear when the additive utility functions are used to classify alternatives that have not been considered during the model building process (extrapolation). Although this situation is rare, its occurrence indicates that the classication of the alternatives is not clear and additional analysis is required. This analysis can be based on the examination of the marginal utilities C $C ui j gi a and ui j gi a to determine how the

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Fig. 2. The iterative binary segmentation procedure.

Since, in linear programming it is not possible to use strict inequality constraints, a small positive real number s may be used as follows: U Ck a U $Ck a P s and U $Ck b U Ck b P s: If these constraints are not satised, then the corresponding alternatives are misclassied (a is classied into a lower group than Ck and b is classied into Ck ). The classication errors in this case are ea U $Ck a U Ck a s and eb U Ck b U $Ck b s. Consequently, the initial linear program (LP1) to be solved can be formulated as follows: X X min F ea eb s:t: U Ck a U $Ck a ea P s 8a 2 Ck ; U $Ck b U Ck b eb P s 2

8b 62 Ck ; wCk P t; w$Ck P t; ij;j1 ij;j1 XX C X X $C k k wij;j1 1; wij;j1 1;

i j i j

3 4 5

ea; s; t P 0: Constraints (4) are used to ensure the monotonicity of the marginal utilities, while constraints (5) are normalization constraints ensuring that the global utility of an alternative will be in the interval 0; 1. 2.3.2. MIP: Minimizing the number of misclassications If after the solution of LP1, there exist some alternatives a 2 A for which ea > 0, then obviously these alternatives are misclassied. However, it may be possible to achieve a rearrangement of the classication errors that leads to the reduction of the total number of misclassications. This is achieved through a mixed-integer programming

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formulation (MIP). Since MIP formulations are dicult to solve, especially in cases where the number or integer variables is large, the MIP formulation used in the proposed binary segmentation procedure, considers only the misclassications that occur through the solution of LP1, while retaining all the correct classications. This reduces signicantly the number of integer variables (integer variables are associated to each misclassied alternative), thus reducing the computational eort required to obtain a solution. Let COR be the set of correctly classied alternatives after solving LP1, and MIS be the set of misclassied alternatives for which ea > 0. The MIP formulation is the following: X min F Ia Ib
8a;b2MIS

U Ck a U $Ck a > 1 s, 8a 62 Ck . Clearly, this second case should be avoided if possible (the classication error in this case is severe), and setting Ia 2 provides the model with the ability to distinguish among these two situations. 2.3.3. LP2: Maximizing the minimum distance Through the solution of LP1 and MIP the optimal classication of the alternatives is achieved, where the term optimal refers to the minimization of the total number of misclassied alternatives. However, the correct classication of some alternatives may have been marginal, that is, although they are correctly classied, their global utilities according to the two developed utility functions may have been very close. The objective of LP2 is to clarify the obtained classication, through the maximization of the minimum dierence between the global utilities of the correctly classied alternatives achieved according to the two utility functions. Similarly to MIP, let COR0 be the set of correctly classied alternatives after solving LP1 and MIP, and MIS0 be the set of misclassied alternatives. LP2 can be formulated as follows: max s:t: d U Ck a U $Ck a d P s 8a 2 Ck U $Ck b U Ck b d P s 8b 62 Ck 8a; b 2 COR0 ; U a U a 6 0 U $Ck b U Ck b 6 0 8a; b 2 MIS0 ; wCk ij;j1
i Ck $Ck

s:t:

U a U $Ck a P s
Ck

8a 2 Ck 8b 62 Ck

 6

U $Ck b U Ck b P s 8a; b 2 COR; U a U U

$Ck Ck $Ck Ck

a Ia P s

8a 2 Ck 8b 62 Ck

b U b Ib P s 8a; b 2 MIS; w$Ck ij;j1

wCk ij;j1
i

P t; P t; X X $C XX C k k wij;j1 1; wij;j1 1;
j i j

 8

s P 0; t P 0; Ia integer: The rst set of constraints (6) ensures that all correct classications achieved by solving LP1 are retained. The second set of constraints (7) applies only to alternatives that were misclassied by LP1. Their meaning is similar to the constraints (2) and (3) in LP1, with the only dierence being the transformation of the continuous error variables e of LP1 (classication errors) into integer error variables I indicating whether an alternative is misclassied or not. The integer variables Ia can take three possible values: 0, 1 or 2. If Ia 0, then alternative a is correctly classied. On the contrary, if Ia 1 or Ia 2, then alternative a is misclassied. The dierence between these two situations (Ia 1 and Ia 2) is that in the former case U $Ck a U Ck a 6 1 s, 8a 2 Ck and U Ck a U $Ck a 6 1 s, 8a 62 Ck , while in the later case U $Ck a U Ck a > 1 s, 8a 2 Ck and

8a 2 Ck 8b 62 Ck

P t; P t; X X $C XX C k k wij;j1 1; wij;j1 1;
j i j

w$Ck ij;j1

d; s; t P 0: The rst set of constraints (8) involves only the correctly classied alternatives. In these constraints d represents the minimum absolute dierence between the global utilities of each alternative according to the two utility functions. The second set of constraints (9) involves the misclassied alternatives and it is used to ensure that they will be retained as misclassied.

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Having solved the three aforementioned mathematical programming formulations, and if stage k is the last stage of the binary segmentation procedure (i.e., k q 1) then the procedure stops. Otherwise, if k < q 1 then the procedure proceeds to stage k 1, where the aim is to discriminate among the alternatives belonging into group Ck1 and the alternatives belonging into all the other lower groups Cj j > k 1. In this stage all the alternatives that were found in the previous stage to belong into group Ck , are not considered. Consequently, a new set A0 of alternatives is formed, including all the alternatives for which their specic classication is not yet determined. According to the set A0 the values of pi , gi1 and gipi are updated, and the procedure proceeds in solving once again LP1, MIP and LP2. 2.4. Model extrapolation The classication of a new alternative a 62 A is achieved by descending the decision tree of Fig. 2. Initially, the two rst additive utility functions U C1 a and U $C1 a are used to determine whether an alternative a belongs into group C1 or not. If U C1 a > U $C1 a then a 2 C1 and the procedure stops, while if U C1 a < U $C1 a then a 62 C1 and the procedure proceeds with the consideration of the next pair of utility functions U C2 a and U $C2 a . If U C2 a > U $C2 a then a 2 C2 and the procedure stops, while if U C2 a < U $C2 a then a 62 C2 , and the procedure continues in the same way until the classication of the new alternative is achieved. To estimate the global utility of a new alternative a, the partial value (marginal utility) of this alternative on each one of the evaluation criteria must be determined. If gi a 2 Vi then the marginal utility $C ui k gi a is already known (the notation ($) is used to consider the pair of utility functions developed at stage k of the binary segmentation pro$C cess). On the contrary, if gi a 62 Vi then ui k gi a can be estimated through linear interpolation.

the proposed approach to support the study of complex real world discrimination problems. These applications involve the following problems: (1) credit cards assessment, (2) country risk evaluation, (3) credit risk assessment, (4) prediction of corporate acquisitions, and (5) business failure prediction. A comparison with discriminant analysis (DA) and the UTADIS MCDA sorting method is also performed. 3.1. Data and methodology The ve nancial applications that are considered involve a variety of sample sizes and characteristics. In credit cards assessment 150 credit card applications are considered, described along seven evaluation criteria (six qualitative and one quantitative). The applications are classied into three groups, i.e., acceptable (C1 ), applications requiring further investigation (C2 ), rejectable (C3 ). In country risk evaluation 143 countries are considered and classied into four groups according to their economic performance (high income economies C1 , upper-middle income economies C2 , lower-middle income economies C3 , low-income economies C4 ) following the methodology employed by the World Bank. Twelve economic indices are used as evaluation criteria. The credit risk assessment problem involves the classication of 60 rms into two groups, i.e., the nancially sound rms (C1 ), and the rms facing nancial problems (C2 ). The nancial position of the rms is described along 12 nancial ratios (protability, solvency/liquidity, and managerial performance ratios). Three years data are employed in this case study. The most recent one is used as the reference set to develop the appropriate discrimination model, while the two previous years are used to test its extrapolating ability. A similar approach is also used in for the prediction of corporate acquisitions. Three years data involving 10 nancial characteristics (ratios) of 30 non-acquired and 30 acquired rms are considered (groups C1 and C2 , respectively). The rst year prior to acquisition is used as the reference set to develop a model that discriminates between acquired and non-acquired rms, while the previous two years prior to acquisition are used to test the extrapolating ability

3. Applications Five applications from the eld of nance are presented in this section to illustrate the ability of

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of the developed model. Finally, in business failure prediction two samples of rms are considered. The rst one (basic sample) includes 80 rms used during model development, while the second sample (holdout sample) consists of 38 rms used for model validation. Both samples include equal number of non-failed (category C1 ) and failed rms (category C2 ). All rms are evaluated along a set of 12 nancial ratios. This form of information is available for a ve-year period in the basic sample (years )1, )2, )3, )4 and )5 prior to failure) and for a three-year period in the case of the holdout sample (years )1, )2, and )3 prior to failure). Similarly to the applications involving the credit risk assessment problem and the prediction of corporate mergers and acquisitions, the data of the rms of the basic sample for the rst year prior to failure (year )1) are used to develop the appropriate business failure prediction model. The remaining four years of the basic sample and the three years of the holdout sample are used to validate the eciency of the developed model in providing helpful decision support in estimating the business failure risk. Table 1 summarizes the characteristics of the samples used in each application, while the evaluation criteria that are considered are illustrated in Appendix A. More details on these applications can be found in Zopounidis et al. (1998), Pentaraki (1998), Doumpos and Zopounidis (1998), Slowinski et al. (1997) and Dimitras et al. (1999). 3.2. Presentation of results The application of the iterative binary segmentation procedure in credit risk evaluation and

corporate acquisition resulted to the correct classication of all the alternatives (rms) that were considered during the model development process (i.e., the developed models classied correctly all the rms in the most recent year of the analysis, year )1). Thus, the solution of MIP was not necessary since there were no misclassications. In the case of business failure prediction, the solution of LP1 resulted into two misclassications. The subsequent solution of MIP did not change this classication of the rms. Furthermore, since in all these three problems there are only two classes, the iterative binary segmentation process consists of only one stage, and two additive utility functions are developed. These functions are used to discriminate among the nancially sound rms and the rms facing nancial problems (in the credit risk assessment problem), among acquired and non-acquired rms (in the corporate acquisition problem), and among the non-failed and the failed rms in business failure prediction. Concerning the other two applications, the credit cards assessment problem and the evaluation of country risk, the iterative binary segmentation process consists of multiple stages. In credit cards assessment it consists of two stages: stage 1 discriminates among the acceptable credit card applications and all the others, while stage 2 discriminates between the credit card applications requiring further investigation and the rejectable applications. In country risk evaluation the iterative binary segmentation process consists of three stages: in the rst stage the discrimination among the countries belonging into the high-income economies group and the countries belonging into the rest of the classes is performed. In the second

Table 1 Samples characteristics in the ve case studies Case study Alternatives Criteria Alternatives per group C1 Credit cards Country risk Credit risk Corporate acquisitions Business failure prediction 150 143 60 60 80 (basic sample) 38 (holdout sample) 7 12 12 10 12 74 31 30 30 40 C2 52 21 30 30 40 C3 24 42 C4 49

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stage the countries belonging to the upper-middle income economies group are discriminated from the countries of the lower-middle and the low-income economies groups. Finally, the third stage involves the discrimination among the countries of the lower-middle and the low-income economies groups. In both credit cards assessment and country risk evaluation, the discrimination model developed through the proposed approach is not able to correctly classify all the alternatives (i.e., credit card applications, countries) into their original classes. In credit cards assessment there are two credit card applications that are misclassied (overall classication accuracy 98.67%), while in country risk evaluation there is one misclassied country (overall classication accuracy 99.3%). It is interesting to examine how these errors evolve during the iterative binary segmentation process. In credit cards assessment the solution of LP1 in the rst stage of the binary segmentation process results into four misclassications (classication accuracy 97.33%). One of these misclassications is of the type C1 ! C2 _ C3 (an acceptable credit card application is classied into one of the two other groups), while the other three misclassications are of the type C2 ! C1 (applications requiring further consideration are classied as acceptable ones). Then, the iterative binary segmentation procedure, proceeds to the solution of MIP, which involves only four integer variables corresponding to the aforementioned misclassications. Thus, its solution is computationally tractable. The pair of additive utility functions developed after solving MIP increases the classication accuracy to 98.67% (two of the initially four misclassied credit card applications are classied correctly). The retained misclassications involve the C1 ! C2 _ C3 misclassication and one of the C2 ! C1 misclassications. The later misclassication (C2 ! C1 ) will be ignored in the next stage of the binary segmentation process, since the classication of the corresponding credit card application is specically determined, although in an incorrect way. The solution of LP2 does not aect the classication accuracy but it claries the obtained classication. In the second stage of the binary segmentation process, the initially misclas-

sied acceptable credit card application is treated as an application requiring further consideration. Bearing in mind this remark, the solution of LP1 classies correctly all the credit card applications. Thus the procedure ends with the solution of LP2. The discrimination procedure is simpler in the country risk evaluation problem. In the rst stage there are no misclassications. In the second stage, solving LP1 results to one misclassied country, China, which is classied into the group of upper-middle income economies while belonging in the group of low-income economies. Since there is only one misclassication MIP is not solved, and the procedure proceeds with the solution of LP2. China is ignored during the third stage of the binary segmentation process, after which no additional classication errors are encountered. Appendix B illustrates the additive utility functions developed for each of the ve applications, along with the corresponding discrimination rules, while Tables 24 present the obtained classication results. The elements on the diagonal correspond to the correct classications (classication accuracy). All the other elements of the tables indicate misclassications (classication error). Concerning the credit risk assessment problem, as well as the corporate acquisition problem, it should be pointed out that year )1 (most recent year) is used to develop the appropriate discrimination models, which are then extrapolated on the data of the rms in years )2 and )3. In business failure prediction, year )1 of the basic sample is used for model development and the remaining years of the basic and the holdout sample are used for model validation. According to the obtained results it is clear that the iterative binary segmentation procedure is able to provide high classication accuracy (overall accuracy) in the sample used for model development. This is evident from the classication accuracy obtained in credit cards assessment and country risk evaluation (the corresponding samples are used only for model development purposes), as well as from the classication accuracy (100%) that is obtained in year )1 in credit risk assessment and corporate acquisitions.

C. Zopounidis, M. Doumpos / European Journal of Operational Research 139 (2002) 371389 Table 2 Classication results in credit cards assessment and country risk evaluation Original classication Estimated classication C1 (%) Credit cards C1 C2 C3 Country risk C1 C2 C3 C4 98.65 1.92 100 C2 (%) 1.35 98.08 100 2.04 C3 (%) 100 100 C4 (%) 97.96 98.67 Overall accuracy (%)

381

99.3

Table 3 Classication results in credit risk assessment and corporate acquisitions Original classication Estimated classication Year )1 C1 (%) Credit risk C1 C2 Overall accuracy Corporate acquisitions C1 C2 Overall accuracy 100 100 100 100 C2 (%) 100 Year )2 C1 (%) 96.67 20 88.33 50 33.33 58.33 C2 (%) 3.33 80 Year )3 C1 (%) 86.67 20 83.33 63.33 40 61.67 C2 (%) 13.33 80

100

50 66.67

36.67 60

The extrapolating results obtained in the credit risk assessment problem are also encouraging, since the developed model is able to classify correctly 83.33% of the rms up to three years prior to the occurrence of nancial diculties. Similar results (in terms of the eectiveness of the proposed approach) are also obtained in business failure prediction. The lower performance of the method in the holdout sample is due to the fact that the data of this sample involve dierent time period than the one considered in the basic sample. In the corporate acquisition problem the classication accuracy (overall accuracy) during the extrapolation of the developed model in the previous two years prior to acquisition is rather poor. However, this is not necessarily due to the inability of the proposed approach to develop an appropriate discrimination model, but is mainly caused

by the nature of the corporate acquisition problem itself. In that sense, it should be noticed that the development of the discrimination model to predict corporate acquisitions was based only on nancial data (nancial ratios), which are not always the determinant factors of corporate acquisition. Indeed, several authors on this eld have pointed out that corporate acquisitions are often part of a strategic plan for corporate development, rather than the result of poor nancial performance of the acquired rm (Belkaoui, 1978; Slowinski et al., 1997). This fact indicates that introducing qualitative data regarding the management of the rms, their organization, their market share, the market trend, etc., could result in the development of a more appropriate model for predicting corporate acquisitions. Such information was unavailable in this case study.

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Table 4 Classication results in business failure prediction Original classication Estimated classication C1 (%) Basic sample Year )1 C1 C2 Year )2 C1 C2 Year )3 C1 C2 Year )4 C1 C2 Year )5 C1 C2 Holdout sample Year )1 C1 C2 Year )2 C1 C2 Year )3 C1 C2 95.00 87.50 10.00 82.50 15.00 72.50 30.00 77.50 27.50 5.00 100.00 12.50 90.00 17.50 85.00 27.50 70.00 22.50 72.50 97.50 C2 (%) Overall accuracy

88.75

83.75

71.25

75.00

57.90 21.05 68.42 36.84 73.69 36.84

42.10 78.95 31.58 63.16 26.31 63.16

68.43

65.79

68.43

3.3. Comparison with alternate classication procedures In order to investigate the relative performance of the proposed preference disaggregation procedure as opposed to other classication techniques, this section reports the results of the comparison with discriminant analysis (DA) and the UTADIS method (Zopounidis and Doumpos, 1999). DA is a multivariate statistical technique that leads to the development of a linear discriminant function that maximises the ratio of among-group to within-group variability, assuming that the variables are normally distributed and that the dispersion matrices among groups are equal (in the linear case). The selection of DA for compar-

ison purposes in this case study was decided upon the popularity of the method in the eld of nance as an approach to study nancial decision problems. Furthermore, DA is commonly used by researchers to evaluate the performance of new discrimination algorithms and approaches. On the other hand, the UTADIS method represents the MCDA approach to the classication problem. The method employs a similar modelling form to the one used in the proposed iterative binary segmentation procedure, in order to represent the decision makers preferential system. In particular, the UTADIS method leads to the development of an additive utility function that is used to evaluate the performance of the alternatives and decide upon their classication. Details on the model development process that is used in the UTADIS method can be found in Zopounidis and Doumpos (1999). The major dierence between the UTADIS method and the proposed approach is that the former does not employ an iterative classication procedure. Furthermore, in the additive utility model developed through the UTADIS characterizes all the alternatives and not just the ones that belong in a specic class, as in the case of proposed iterative binary segmentation procedure. Therefore, the consideration of the UTADIS method in this comparison enables the derivation of useful remarks with regard to the relative performance of these two similar MCDA approaches. Tables 57 present the classication results obtained through the application of DA and UTADIS. These results are indicative of the superiority of the iterative binary segmentation procedure as opposed to DA in all the four considered case studies. In credit cards assessment and country risk evaluation, where the discrimination models developed are not extrapolated, the proposed iterative binary segmentation procedure provides signicantly better classication results than DA. The dierence between the classication accuracy of the two methods is 10% in the credit cards assessment problem (98.67% for the iterative binary segmentation procedure versus 88.67% for DA), and 21.68% in the country risk evaluation problem (99.3% for the iterative binary segmentation procedure versus 77.62% for DA). In credit risk as-

C. Zopounidis, M. Doumpos / European Journal of Operational Research 139 (2002) 371389 Table 5 DA and UTADIS results in credit cards assessment and country risk evaluation Original classication Estimated classication C1 (%) Discriminant analysis Credit cards C1 C2 C3 Country risk C1 C2 C3 C4 UTADIS Credit cards C1 C2 C3 Country risk C1 C2 C3 C4 C2 (%) C3 (%) C4 (%)

383

Overall accuracy (%)

90.54 7.69 90.32 9.52 4.76

8.11 88.46 16.67 38.1 4.76 2.04

1.35 3.85 83.33 9.68 42.86 83.33 16.33

9.52 7.14 81.63

88.67

77.62

97.30 1.92 90.32

2.70 98.08 9.67 42.85 16.67 2.04

100.00 57.14 80.95 12.24

2.38 85.71

98.00

79.02

Table 6 DA and UTADIS results in credit risk assessment and corporate acquisitions Original classication Estimated classication Year )1 C1 (%) Discriminant analysis Credit risk C1 C2 Overall accuracy Corporate acquisitions C1 C2 Overall accuracy UTADIS Credit risk C1 C2 Overall accuracy Corporate acquisitions C1 C2 Overall accuracy C2 (%) Year )2 C1 (%) C2 (%) Year )3 C1 (%) C2 (%)

93.33 3.33 95 73.33 33.33 70

6.67 96.67

90 20 85 53.33 43.33 55

10 80

83.33 30 76.67 46.67 30 58.33

16.67 70

26.67 66.67

46.67 56.67

53.33 70

100.00 100 87.67 16.67 85

100.00

90 6.67 91.67 56.67 40.00 58.33

10 93.33

83.33 26.67 78.33 50.00 33.33 58.33

16.67 73.33

13.33 83.33

43.33 60.00

50.00 66.67

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Table 7 DA and UTADIS results in business failure prediction Original classication Discriminant analysis Estimated classication C1 (%) Basic sample Year )1 C1 C2 Year )2 C1 C2 Year )3 C1 C2 Year )4 C1 C2 Year )5 C1 C2 Holdout sample Year )1 C1 C2 Year )2 C1 C2 Year )3 C1 C2 C2 (%) Overall accuracy (%) UTADIS Estimated classication C1 (%) C2 (%) Overall accuracy (%)

92.50 12.50 87.50 25.00 87.50 32.50 85.00 45.00 80.00 45.00

7.50 87.50 12.50 75.00 12.50 67.50 15.00 55.00 20.00 55.00

90.00

100.00 0.00 85.00 17.50 87.50 20.00 80.00 30.00 82.50 40.00

0.00 100.00 15.00 82.50 12.50 80.00 20.00 70.00 17.50 60.00

100.00

81.25

83.75

77.50

83.75

70.00

75.00

67.50

71.25

68.42 36.84 73.68 57.89 73.68 63.16

31.58 63.16 26.32 42.11 26.32 36.84

65.79

52.63 26.32 63.16 47.37 78.95 52.63

47.37 73.68 36.84 52.63 21.05 47.37

63.16

57.90

57.90

55.26

63.16

sessment and prediction of corporate acquisitions, the proposed approach once again performs signicantly better on the data used for model development purposes (year )1), especially in the corporate acquisitions problem (the classication accuracy of the proposed approach is 100% versus 70% of DA). In years )2 and )3 where the developed discrimination models are extrapolated, the dierences between the iterative binary segmentation procedure and DA are less signicant. Nevertheless, the proposed MCDA approach still provides higher classication accuracy. In year )2 for credit risk assessment, as well as in years )2 and )3 for corporate acquisitions the dierence between the classication accuracy of the iterative

binary segmentation procedure as opposed to DAs accuracy is 3.33%, while in year )3 for credit risk assessment the dierence is increased to 6.66%. Finally, in business failure prediction the iterative binary segmentation procedure outperforms DA in all years both in the basic and the holdout sample. As opposed to the UTADIS method, the proposed MCDA approach provides signicantly higher classication accuracy in the samples used for model development (reference sets), especially in the case of the more complex problems involving the country risk assessment problem and the prediction of corporate acquisitions (year )1). Furthermore, the classication models developed

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385

through the iterative binary segmentation procedure also provide high generalizing ability. The results obtained in years )2 and )3 in the credit risk assessment problem and the prediction of corporate acquisitions, illustrate that the iterative binary segmentation procedure is able to provide at least comparable results with the ones provided by the alternate preference disaggregation approach, namely the UTADIS method. Finally, in business failure prediction both the UTADIS method and the proposed iterative binary segmentation procedure provide similar results in the basic sample. However, the results of the iterative binary segmentation procedure are superior to the ones of the UTADIS method in all three years of the holdout sample (additional details on the results of the UTADIS method in business failure prediction can be found in Zopounidis and Doumpos (1999)).

4. Conclusions In this paper a new MCDA method has been proposed for discriminating among alternatives or objects belonging into dierent predened homogeneous ordered classes (groups). The consideration of the proposed MCDA iterative binary segmentation procedure method extends the existing framework of the preference disaggregation approach, through the development of a series of additive utility functions representing the value of the decisions concerning the classication of the alternatives into a specic class or not. The iterative binary segmentation procedure that is employed, as well as the sequential consideration of three dierent discrimination measures enables the method to achieve high discrimination accuracy, without being computationally intensive as several methods, based on mixed-integer programming formulations are. Of course, the proposed approach is not the only MCDA classication methodology that is based on utility-based aggregation model. However, most of the existing MCDA approaches (e.g., the UTADIS method; Zopounidis and Doumpos, 1999) assume that there exists a global evaluation model in the form of an outranking relation or a

utility function that describes the decision makers preferential system in evaluating all alternatives. However, it is often the case that, for instance, an evaluation criterion can be signicant in characterizing the alternatives belonging into class C1 , but the same criterion can be insignicant in characterizing the alternatives belonging into class C2 . The iterative binary segmentation procedure enables the modeling of such cases in order to represent more accurately the decision makers preferences and judgment. Of course, these theoretical advantages of the proposed approach should be explored in practice through appropriate applications and comparisons with alternative MCDA approaches. The ve illustrative applications that were presented showed that the iterative binary segmentation procedure provides high discrimination and extrapolating accuracy, both in dichotomous as well as in multi-group discrimination problems. The comparison with discriminant analysis using four real world case studies from the eld of nance, demonstrated that the proposed approach could outperform a wellknown discrimination method. The application of the method in other real world discrimination decision problems as well as the conduct of simulation tests could provide more insight information regarding the performance of the method compared to other MCDA discrimination methods, but also to well-known parametric approaches such as discriminant, logit and probit analysis, and other discrimination techniques including neural networks, rough sets, and mathematical programming formulations.

Appendix A. See Table 8.

Appendix B. Additive utility functions and classication rules B.1. Credit cards assessment  Stage 1:

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Table 8 Evaluation criteria used in the ve applications Application Credit cards Country risk Evaluation criteria (g1 ) Family status, (g2 ) business phone number, (g3 ) residence, (g4 ) bank account for credit card payments, (g5 ) applicants age, (g6 ) profession, (g7 ) years in business (g1 ) Current account balance/GDP, (g2 ) export volume growth, (g3 ) gross domestic investment/GDP, (g4 ) import volume growth, (g5 ) ination (GDP deator), (g6 ) net trade in goods and services, (g7 ) present value of debt/exports of goods and services, (g8 ) present value of debt/GNP, (g9 ) total debt service/GNP, (g10 ) income velocity of money (GDP/M2), (g11 ) GNP growth, (g12 ) gross international reserves in months of imports (g1 ) Earnings before interest and taxes/total assets, (g2 ) net income/net worth, (g3 ) net income/sales, (g4 ) net worth/total liabilities, (g5 ) total liabilities/total assets, (g6 ) current assets/current liabilities, (g7 ) (current assets inventories)/current liabilities, (g8 ) cash/ current liabilities, (g9 )dividends/cash ow, (g10 ) working capital/total assets, (g11 ) interest expenses/sales, (g12 ) current liabilities/inventories (g1 ) Earnings before interest and taxes /total assets, (g2 ) cash ow/total assets, (g3 ) net income/net worth, (g4 ) cash/total assets, (g5 ) (long term debt + current liabilities)/total assets, (g6 ) (long term debt + current liabilities)/cash ow, (g7 ) net worth/(net worth + long term debt), (g8 ) quick assets/current liabilities, (g9 ) current assets/current liabilities, (g10 ) working capital/total assets (g1 ) Net income/gross prot, (g2 ) gross prot/total assets, (g3 ) net income/total assets, (g4 ) net income/net worth, (g5 ) current assets/current liabilities, (g6 ) quick assets/current liabilities, (g7 ) (long term debt + current liabilities)/total assets, (g8 ) net worth/(net worth + long term debt), (g9 ) net worth/net xed assets, (g10 ) inventories/working capital, (g11 ) current liabilities/total assets, (g12 ) working capital/net worth

Credit risk

Corporate acquisitions

Business failure prediction

U C1 a 0:0002uC1 g1 0:0798uC1 g2 1 2 0:5599uC1 g3 0:2796uC1 g4 3 4 0:0002uC1 g5 0:0802uC1 g6 5 6 0:0001uC1 g7 ; 7 U $C1 a 0:3194u$C1 g1 0:0796u$C1 g2 1 2 0:0009u$C1 g3 0:1196u$C1 g4 3 4 0:0002u$C1 g5 0:1596u$C1 g6 5 6 0:3207u$C1 g7 : 7  Stage 2: U C2 a 0:1176uC2 g1 0:0003uC2 g2 1 2 0:4124uC2 g3 0:2344uC2 g4 3 4 0:0002uC2 g5 0:2351uC2 g6 ; 5 6 U $C2 a 0:3525u$C2 g1 0:0003u$C2 g2 1 2 0:41u$C2 g3 0:0017u$C2 g4 3 4 0:2353u$C2 g5 0:0002u$C2 g6 : 5 6

 Classication rule: If U C1 a > U $C1 a then a 2 Acceptable applications C1 Else if U C2 a > U $C2 a then a2 Applications for further consideration C2 Else a 2 Rejectable applications C3 B.2. Country risk evaluation  Stage 1: U a 0:0093uC1 g1 0:0137uC1 g2 1 2
C1

0:0095uC1 g3 0:02uC1 g4 3 4 0:0127uC1 g5 0:0112uC1 g6 5 6 0:8668uC1 g7 0:0099uC1 g8 7 8 0:0103uC1 g9 0:0113uC1 g10 9 10 0:0136uC1 g11 0:0117uC1 g12 ; 11 12 U $C1 a 0:0894u$C1 g1 0:0137u$C1 g2 1 2 0:0095u$C1 g3 0:0113u$C1 g4 3 4

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0:0592u$C1 g5 0:0112u$C1 g6 5 6 0:7489u$C1 g7 0:0099u$C1 g8 7 8 0:0103u$C1 g9 0:0113u$C1 g10 9 10 0:0136u$C1 g11 0:0117u$C1 g12 : 11 12  Stage 2: U a 0:0068uC2 g1 0:0602uC2 g2 1 2
C2

 Classication rule: If U C1 a > U $C1 a then a 2 High-income economies C1 Else if U C2 a > U $C2 a then a 2 Uppermiddle income economies C2 Else if U C3 a > U $C3 a then a 2 Lowermiddle income economies C3 Else a 2 Low-income economies C4 B.3. Credit risk assessment  Stage 1: U C1 a 0:0059uC1 g1 0:0037uC1 g2 1 2 0:9417uC1 g3 0:0059uC1 g4 3 4 0:0059uC1 g5 0:0058uC1 g6 5 6 0:0056uC1 g7 0:0049uC1 g8 7 8 0:0029uC1 g9 0:0059uC1 g10 9 10 0:0059uC1 g11 0:0059uC1 g12 ; 11 12 U $C1 a 0:9205u$C1 g1 0:0119u$C1 g2 1 2 0:0189u$C1 g3 0:0059u$C1 g4 3 4 0:0059u$C1 g5 0:0058u$C1 g6 5 6 0:0056u$C1 g7 0:0049u$C1 g8 7 8 0:0029u$C1 g9 0:0059u$C1 g10 9 10 0:0059u$C1 g11 0:0059u$C1 g12 : 11 12  Classication rule: If U C1 a > U $C1 a then a 2 High risk firms C1 Else a 2 Low risk firms C2 B.4. Corporate acquisitions  Stage 1: U C1 a 0:0569uC1 g1 0:8104uC1 g2 1 2 0:0059uC1 g3 0:0183uC1 g4 3 4 0:0396uC1 g5 0:0059uC1 g6 5 6 0:0043uC1 g7 0:0496uC1 g8 7 8 0:0059uC1 g9 0:0059uC1 g10 ; 9 10

0:2635uC2 g3 0:0087uC2 g4 3 4 0:0576uC2 g5 0:2099uC2 g6 5 6 0:0167uC2 g7 7 0:0098uC2 g8 8 0:0102uC2 g9 0:1263uC2 g10 9 10 0:0107uC2 g11 0:2195uC2 g12 ; 11 12 U $C2 a 0:1086u$C2 g1 0:0251u$C2 g2 1 2 0:0069u$C2 g3 0:1116u$C2 g4 3 4 0:0261u$C2 g5 0:2502u$C2 g6 5 6 0:0157u$C2 g7 0:0641u$C2 g8 7 8 0:0102u$C2 g9 0:2128u$C2 g10 9 10 0:1171u$C2 g11 0:0516u$C2 g12 : 11 12  Stage 3: U C3 a 0:0052uC3 g1 0:1806uC3 g2 1 2 0:3212uC3 g3 3 0:008uC3 g5 5 0:0068uC3 g4 4 0:1627uC3 g6 6

0:1183uC3 g7 0:0082uC3 g8 7 8 0:0085uC3 g9 0:0757uC3 g10 9 10 0:0086uC3 g11 0:0963uC3 g12 ; 11 12 U $C3 a 0:2597u$C3 g1 0:0085u$C3 g2 1 2 0:1386u$C3 g3 0:0068u$C3 g4 3 4 0:008u$C3 g5 0:1949u$C3 g6 5 6 0:0943u$C3 g7 0:0082u$C3 g8 7 8 0:0085u$C3 g9 0:1222u$C3 g10 9 10 0:1187u$C3 g11 0:0313u$C3 g12 : 11 12

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Table 9 Discriminant functions developed in the ve applications Evaluation criteria g1 g2 g3 g4 g5 g6 g7 g8 g9 g10 g11 g12 Constant Credit cards 0.8510 )0.0960 1.0750 )0.0134 0.0486 0.5389 )0.0109 0.0644 )0.0666 0.0087 )0.0199 0.9725 0.7925 )2.2257 Country risk )0.0591 )0.0086 )0.0093 0.0113 )0.0031 0.0000 0.0044 )0.0007 0.0176 0.4736 0.0259 0.0566 )2.7318 )0.0010 )0.0014 0.0740 )0.0089 0.0152 0.0000 )0.0009 )0.0007 0.0794 )0.0276 )0.0143 0.2040 )2.4615 )0.0666 0.0178 0.0262 0.0020 0.0124 0.0000 )0.0061 0.0082 )0.0588 0.0890 0.1088 0.0279 )1.3111 Credit risk 9.9765 )0.9044 3.6599 )0.3304 )2.3474 )0.9109 1.5524 )1.1413 0.0653 2.5665 )2.1727 )0.0345 0.3884 Corporate acquisitions 3.7266 )0.5321 0.2847 7.4376 )1.9057 )0.0074 0.5400 )1.5716 1.5488 )1.8982 Business failure 0.0093 1.9154 2.4196 0.1245 1.2882 )0.9008 )0.7149 0.0004 0.0342 )0.0168 0.6294 0.0022 )1.1510

)7.4721

)1.6369

)0.2744

U $C1 a 0:0057u$C1 g1 0:0576u$C1 g2 1 2 0:0059u$C1 g3 0:0041u$C1 g4 3 4 0:0052u$C1 g5 0:0059u$C1 g6 5 6 0:8979u$C1 g7 7 0:0059u$C1 g9 9 0:0059u$C1 g8 8 0:0059u$C1 g10 : 10

0:0085u$C1 g9 0:0079u$C1 g10 9 10 0:0079u$C1 g11 0:0073u$C1 g12 : 11 12  Classication rule: If U C1 a > U $C1 a then a 2 Non-failed firms C1 Else a 2 Failed firms C2 Appendix C. See Table 9. References

 Classication rule: If U C1 a > U $C1 a then a 2 Non-failed firms C1 Else a 2 Acquired firms C2 B.5. Business failure prediction  Stage 1 U C1 a 0:0523uC1 g1 0:0079uC1 g2 1 2 0:8531uC1 g3 0:0068uC1 g4 3 4 0:0079uC1 g5 0:0079uC1 g6 5 6 0:0281uC1 g7 0:0050uC1 g8 7 8 0:0079uC1 g9 0:0079uC1 g10 9 10 0:0079uC1 g11 0:0073uC1 g12 ; 11 12 U $C1 a 0:0079u$C1 g1 0:0079u$C1 g2 1 2 0:0385u$C1 g3 0:0068u$C1 g4 3 4 0:0079u$C1 g5 0:0079u$C1 g6 5 6 0:8865u$C1 g7 0:0050u$C1 g8 7 8

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