How Leverage and Default Risk Affect the Cost of Equity

Summary

The document raises questions about how leverage and default risk affect a firm’s cost of equity, debt costs, weighted average cost of capital, and valuation. It distinguishes the amount of debt in a capital structure from the risk that the firm may default, asking whether default risk changes equity risk through cash flows or betas even when debt’s share of the capital structure does not change.

It also questions how financial distress costs should enter valuation. One possibility raised is to reflect distress through lower expected cash flows; another is that distress changes the systematic risk of those cash flows and therefore the required returns on equity or debt. The text offers no answers, model, or evidence, so it serves as a conceptual prompt rather than a conclusion about capital structure. Its relevance to trading is indirect, through understanding valuation assumptions and risk measurement.

Key ideas

• Debt amount and default risk are distinct features of a firm’s financing.
• Higher default risk can raise the cost of debt and affect firm value.
• The document asks whether default risk also changes equity beta and the cost of equity.
• Financial distress may affect expected cash flows as well as required returns.
• The questions are unresolved in the document and are not supported by a valuation example.

Tags

# 75205


# In traditional asset pricing and valuation, why does the cost of equity increase with the AMOUNT of leverage but not with DEFAULT RISK?












- When a firm's default risk increases, the cost of debt obviously rises, which increases the WACC and decreases firm value. However, what happens to the cost of equity in this case? Has the proportion of debt in the firm's capital structure fallen (the value of debt has fallen)? This does not make much sense. Is it the case that expected cash flows to equity and therefore equity betas have changed, and the value of both equity and debt has fallen? Is default risk somehow reflected in equity beta (in some other way that is not the weight of debt, which says nothing about how risky that debt is)?

- It is often said that WACC starts increasing at some point with leverage as a result of the costs of financial distress. Given that these are costs, wouldn't it be more accurate to account for them in expected cash flows rather than the WACC? When WACC is said to increase as a result of these costs, is it the increase in the cost of debt or also the increase in the cost of equity? Or does the systematic risk of cash flows increase, hence increasing betas (of equity and debt)? In other words, expected cash flows decrease and the cost of capital increases. This is not double counting of risks in my view, but rather the possibility of calculating betas from cash flows.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.