Costs of Capital under Credit Risk

31 Pages Posted: 10 Jan 2017 Last revised: 17 Jul 2017

See all articles by Peter Reichling

Peter Reichling

Otto-von-Guericke University Magdeburg

Anastasiia Zbandut

Otto-von-Guericke-Universität Magdeburg

Date Written: July 13, 2017

Abstract

Credit risk analysis represents a growing field in financial research since decades. However, in cost of capital computations, credit risk is merely taken into consideration at the level of the debt beta approach. Our paper proves that applications of the debt beta approach suffer from unrealistic assumptions. As an advantageous approach, we develop an alternative framework to determine costs of capital based on Merton’s model. We present (quasi-) analytic formulas for costs of equity and debt which are consistent with Modigliani-Miller theory in continuous-time and discrete-time settings without taxes. Our framework is superior to the debt beta approach regarding the quantity and quality of required data in peer group analysis. Since equity and debt are represented by options in Merton’s model, we compute expected option rates of return. Thereby, our paper is also related to the recently growing literature on expected option returns.

Keywords: Company Valuation, Debt Beta, Merton's Model, WACC

JEL Classification: G13, G32, G33

Suggested Citation

Reichling, Peter and Zbandut, Anastasiia, Costs of Capital under Credit Risk (July 13, 2017). Available at SSRN: https://ssrn.com/abstract=2896148 or http://dx.doi.org/10.2139/ssrn.2896148

Peter Reichling (Contact Author)

Otto-von-Guericke University Magdeburg ( email )

Universitätspl. 2
PSF 4120
Magdeburg, D-39106
Germany
+49 391 6758412 (Phone)
+49 391 6741242 (Fax)

HOME PAGE: http://www.finance.ovgu.de

Anastasiia Zbandut

Otto-von-Guericke-Universität Magdeburg ( email )

Universitätspl. 2
PSF 4120
Magdeburg, D-39106
Germany

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