The purpose of this thesis is to empirically test Merton(1974) model in corporate bond pricing to determine its predictive ability. To estimate unobserable parameters, the firm value and the volatility of the firm value return, iterative technique is used. We examine a cross-section of coupon bonds issued by listed manufacturing firms and traded in March through June, 2001. The results indicate that the model spreads are significantly different from actual spreads and the model underpredicts the spreads of most bonds, We also find that the model predicts much low spreads for bonds that have low debt ratio and short maturity.
