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Costs of capital under credit risk

Author

Listed:
  • Peter Reichling

    () (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg)

  • Anastasiia Zbandut

    () (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg)

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.

Suggested Citation

  • Peter Reichling & Anastasiia Zbandut, 2017. "Costs of capital under credit risk," FEMM Working Papers 170003, Otto-von-Guericke University Magdeburg, Faculty of Economics and Management.
  • Handle: RePEc:mag:wpaper:170003
    as

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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Company valuation; debt beta; expected option return; Merton’s model; WACC;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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