Cost of Capital under Credit Risk
Company valuation is based on determining cost of capital. Cost of capital equals the opportunity cost of an alternative investment on the capital market. This project looks at the first steps of company valuation by ignoring taxes. For the estimation of cost of capital of non-publicly traded companies, the required equity return of a levered company is needed which can be found with a help of the Capital Assets Pricing Model (CAPM). In case of credit risk, the basic leverage formula has to be adjusted by the risk premium of debt in order to estimate required returns on assets and debt by the help of respective betas. For a non-publicly traded company the debt beta formula is also needed for the unlevering-re-levering procedure. This approach assumes a generalized market portfolio that consists of both stocks and corporate bonds. The aim of this project is to show that the debt beta approach causes serious distortion and to apply an option approach to determine cost of capital.
WACC, cost of capital, credit risk, debt beta, option theory
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