Default Risk and Cost of Capital in Corporate Valuation: A Clarification

9 Pages Posted: 26 Dec 2015

See all articles by Alexander D.F. Lahmann

Alexander D.F. Lahmann

Handelshochschule Leipzig (HHL)

Bernhard Schwetzler

HHL Leipzig Graduate School of Management - Department of Finance

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

Lahmann, Alexander D.F. and Schwetzler, Bernhard, Default Risk and Cost of Capital in Corporate Valuation: A Clarification (September 8, 2014). Available at SSRN: https://ssrn.com/abstract=2707965 or http://dx.doi.org/10.2139/ssrn.2707965

Alexander D.F. Lahmann

Handelshochschule Leipzig (HHL) ( email )

Jahnallee 59
Leipzig, 04109
Germany

Bernhard Schwetzler (Contact Author)

HHL Leipzig Graduate School of Management - Department of Finance ( email )

Jahnallee 59
D-04109 Leipzig
Germany
+49-341-9851-685 (Phone)
+49-341-9851-689 (Fax)

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