Costs of capital under credit risk

Peter Reichling () and Anastasiia Zbandut ()
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Peter Reichling: Faculty of Economics and Management, Otto-von-Guericke University Magdeburg
Anastasiia Zbandut: Faculty of Economics and Management, Otto-von-Guericke University Magdeburg

No 170003, FEMM Working Papers from Otto-von-Guericke University Magdeburg, Faculty of Economics and Management

Abstract: Credit risk analysis represents a growing field in financial research since decades. However, in company valuation – to be more precise, 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 without resorting to betas. Thereby, our paper also contributes to the option pricing literature.

Keywords: Company valuation; debt beta; expected option return; Merton’s model; WACC (search for similar items in EconPapers)
JEL-codes: G13 G32 G33 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2017-01
New Economics Papers: this item is included in nep-ban, nep-cfn and nep-fmk
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Persistent link: https://EconPapers.repec.org/RePEc:mag:wpaper:170003

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