The Capital at Risk Model: Theoretical Aspects

Federico Beltrame, Roberto Cappelletto and Gabriele Toniolo
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Federico Beltrame: University of Udine
Roberto Cappelletto: University of Udine

Chapter 3 in Estimating SMEs Cost of Equity Using a Value at Risk Approach, 2014, pp 59-84 from Palgrave Macmillan

Abstract: Abstract Shareholders support entrepreneurial initiative risk in direct correlation with the cyclical nature of their profits and the structure of their operating costs. Moreover, they cover the financial risk associated with the debt level; the higher the financial leverage, the greater the business risk for third-party lenders. This means that for increasing levels of debt, despite any component of financial risk, third-party lenders will be subject to increasing levels of operating risk, taken on total financial responsibility if they remain the only source of contributing capital. This condition is valid in terms of market value but not accounting dimensions as a firm with an asset value in the accounts equal to the value of debts could in any event generate flows so as to remunerate third-party lenders and guarantee a positive equity value. If the market value of the assets were the same as the value of the debts, the credit pricing applied by creditors should be able to completely capture the firm’s operating risk, which the entrepreneur or shareholders would cover in the absence of debt. Given efficient market logic, with equal risk and without taxes, the expected remuneration must be the same, involving a certain alignment between unlevered and totally levered firms. On this point, M. Cattaneo (1999) writes ‘… in this case, the creditors would exclusively hold the right to make use of the operative flows generated by the investments, or they would be de facto shareholders of the firm.

Keywords: Expected Return; Leverage Ratio; Debt Level; Short Term Debt; Risk Capital (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1057/9781137389305_4

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