Costs of capital under credit risk

Peter Reichling and Anastasiia Zbandut

Abstract

In cost-of-capital computations, credit risk is only taken into consideration at the level of the debt beta approach. We show that applications of the debt beta approach in company valuation suffer from unrealistic assumptions about the market index and the cost of debt. As an advantageous approach, we present (quasi-) analytic formulas for costs of equity and debt based on Merton’s model in different settings. In our approach, we integrate credit risk in cost-of-equity and debt calculations to receive the credit risk-adjusted weighted average cost of capital. In addition, we compare both the quantity and the quality of the required data in a peer group analysis of our approach with the data requirements of the debt beta approach. Further, we discuss the valuation errors that result from the debt beta approach’s assumptions regarding the cost of debt. A valuation of Apple Inc as if it were not publicly traded illustrates the procedures of our approach.