A simple correction of the WACC discount rate for default risk and bankruptcy costs

Christian Koziol ()

Review of Quantitative Finance and Accounting, 2014, vol. 42, issue 4, 653-666

Abstract: Standard discounted cash flow approaches suffer from a rudimental modeling of the possibility of a default, as the main characteristics such as the default probability and potential bankruptcy costs are commonly disregarded. This paper aims at providing a tractable extension of the well-known WACC approach for both default risk and bankruptcy costs. The corrected WACC discount rate reveals that default risk results in a systematically higher WACC because the tax component is scaled by the survivorship probability and an aditional component for bankruptcy costs must be added. This difference between the classical WACC discount rate and the simple modified WACC rate can be remarkable especially for firms from businesses with high bankruptcy costs and a relevant default probability. Copyright Springer Science+Business Media New York 2014

Keywords: Firm valuation; Discounted cash flow (DCF); Default risk; WACC approach; G12; G31; G33 (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (19)

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DOI: 10.1007/s11156-013-0356-x

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