Default Risk and Equity Value: Forgotten Factor or Cultural Revolution?
47 Pages Posted: 6 Mar 2018 Last revised: 21 May 2018
Date Written: February 26, 2018
La version française de cet article peut être consultée à: https://ssrn.com/abstract=3065948.
Default risk is the forgotten factor when it comes to equity valuation. And yet, in this article, we show that default risk has a bigger impact on equity values than it does on bond values.
Our work is based on a default intensity model that we extrapolate to equities. This model does not presuppose a particular method for estimating distance to default. As a result, unlike Merton structural models, which only apply to indebted companies, it can be used to assess default risk for any company.
Highlighting a default risk premium in the cost of capital calculation makes it possible to reconcile the CAPM with evaluation methods based on forecasts in the event of survival. At the same time, the CAPM and default risk can explain the vast majority of bond spreads.
The test consisting of estimating “physical” implied default probabilities and the share of systemic risk included in corporate euro bond spreads at end-2015 led us to detect the likely existence of excessive remuneration of investment grade bonds. This finding corroborates identical conclusions reached earlier by other researchers. This potential market anomaly could indicate a windfall for investors. Performing this test again at various points in the economic and financial cycle would help establish whether the bond market is serving a free lunch to investors not bound by regulatory reserve requirements.
Keywords: Cost of Equity, Credit Risk, Default Risk, Credit Spread, Default Spread, Default Premium, Systematic Risk, Cost of Leverage, Cost of Default, APV, Adjusted Present Value, Reduced Form Model, Debt Beta, CAPM, Spread AAA, Implied Cost of Capital, Ex-Ante Equity Risk Premium, Forecast Bias, Optimistic
JEL Classification: G12, G32, G33, M21
Suggested Citation: Suggested Citation