Company Cost of Capital and Leverage: A Simplified Textbook Relationship Revisited

Company Cost of Capital and Leverage: A Simplified Textbook Relationship Revisited

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Abstract In this paper, we revisit a frequently employed simplification within the WACC approach that company cost of capital $$k_{V}$$ k V is supposed to be invariant to the debt ratio and therefore equal to the unlevered cost $$k_{U}$$ k U.Even though we know from Miles click here and Ezzell (1980) that $$k_{V}$$ k V formally differs from $$k_{U}$$ k U , treating both costs as equal strongly facilitates the practical firm valuation e.g.when companies strategically change their target debt ratios to a significantly different magnitude after a transaction.

We provide both a theoretical model and an empirical analysis using 29 firms of the German stock market to quantify the economic significance between the company cost of a levered and an otherwise identical but unlevered firm.In particular, we can numerically support the usual simplification in the absence of default risk.In case that firms are default-risky, however, empirical findings indicate a clear difference between these costs equal to 1.88 percentage points on average even for moderate assumed bankruptcy costs which translates to a company mispricing of nearly 100%.

As a result, the company cost of capital does practically google pixel 7 freedom not depend on the debt ratio if the firm is not subject to default risk or if bankruptcy costs are negligible.Otherwise, it does and a negligence of this relationship can cause significant mispricings.