Default Risk and Cost of Capital in Corporate Valuation: A Clarification
9 Pages Posted: 26 Dec 2015
Date Written: September 8, 2014
Abstract
Koziol (2014) derives a simple adjusted WACC equation for firm valuation that takes default probability, possible loss of future tax savings, and the potential costs of financial distress into account. In this note we show that the derivation of the adjusted formula rests on an assumption that, if valid, renders the proposed adjustment unnecessary: the firm value ignoring shall be equal to the firm value accounting for a potential default. Under this assumption the firm value could always be calculated based on the unadjusted WACC ignoring the potential impact of default. As an overall result, we conclude that default cannot be introduced via a direct adjustment of the standard WACC equation.
Keywords: Firm valuation, Discounted Cash Flow (DCF), Default risk, WACC approach
JEL Classification: G12, G31, G33
Suggested Citation: Suggested Citation