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

Abstract

In this paper, we revisit a frequently employed simplification within the WACC approach that company cost of capital $k_V$ is supposed to be invariant to the debt ratio and therefore equal to the unlevered cost $k_U$ . Even though we know from Miles and Ezzell (1980) that $k_V$ formally differs from $k_U$ , 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 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.

Keywords: Bankruptcy; Cost of capital; Default; Firm value; Leverage.