00 voturi pozitive00 voturi negative

104 vizualizări15 paginiA Simple Correction of the WACC Discount Rate for Default Risk and Bankruptcy Costs

Feb 17, 2016

© © All Rights Reserved

PDF, TXT sau citiți online pe Scribd

A Simple Correction of the WACC Discount Rate for Default Risk and Bankruptcy Costs

© All Rights Reserved

104 vizualizări

00 voturi pozitive00 voturi negative

A Simple Correction of the WACC Discount Rate for Default Risk and Bankruptcy Costs

© All Rights Reserved

Sunteți pe pagina 1din 15

DOI 10.1007/s11156-013-0356-x

ORIGINAL RESEARCH

for default risk and bankruptcy costs

Christian Koziol

Received: 12 March 2012 / Accepted: 22 February 2013 / Published online: 5 March 2013

Springer Science+Business Media New York 2013

Abstract Standard discounted cash flow approaches suffer from a rudimental modeling

of the possibility of a default, as the main characteristics such as the default probability and

potential bankruptcy costs are commonly disregarded. This paper aims at providing a

tractable extension of the well-known WACC approach for both default risk and bankruptcy costs. The corrected WACC discount rate reveals that default risk results in a

systematically higher WACC because the tax component is scaled by the survivorship

probability and an aditional component for bankruptcy costs must be added. This difference between the classical WACC discount rate and the simple modified WACC rate can

be remarkable especially for firms from businesses with high bankruptcy costs and a

relevant default probability.

Keywords

Firm valuation Discounted cash flow (DCF) Default risk WACC approach

1 Introduction

For company valuation purposes, the discounted cash flow (DCF) approach is one of the

most prominent tools. The foundation for this pricing method goes back to Modigliani and

Miller (1963) and was further specified as the adjusted present value (APV) method

proposed by Myers (1974) and the WACC approach presented by Miles and Ezzell (1980).

Not least due to the high tractability, the DCF approach successfully established during the

previous decades. It is now a major part of the corporate finance curriculum at business

schools and it became an intensively applied pricing tool in the financial industry.

Before the background of the wide experiences with the DCF approach in both academia and practice, it might be surprising that the DCF method is still subject to intensive

C. Koziol (&)

Department of Finance, Eberhard Karls University of Tuebingen, 72074 Tubingen, Germany

e-mail: christian.koziol@uni-tuebingen.de

123

654

C. Koziol

discussions: Some authors address common misunderstandings of DCF pricing and show

how to correctly deal with it (see e.g. Inselbag and Kaufold 1997; Graham 2001; Booth

2002; Cooper and Nyborg 2007; Laughton et al. 2008).

Despite the ongoing discussions, there is still one fundamental drawback in the DCF

framework. This shortcoming refers to firms default risk which is typically not taken

into account by the DCF methods. Standard DCF models implicitly assume that tax

shields will arise until the end of the firms planning horizon. Apparently, once a default

takes place, the tax shields, which can attribute to a considerable part of the firm value

(see Graham 2001), are strongly affected. Moreover, a firm exhibits various direct and

indirect costs during a default process.1 Examples for these costs are expenses for

lawyers and consultants (direct bankruptcy costs) as well as the costs that important

managers and employees must care for issues different from their core business and

might consider outside job offers, and the loss of reputation and trust (indirect bankruptcy costs) etc. As a consequence, all these relevant costs in the case of bankruptcy

cannot be taken into account when pricing models such as the DCF approach disregard

default risk. Hence, default is a major issue for the firm value, as in the case of a default

tax shields are reduced or disappear and the firm suffers from additional losses (bankruptcy costs).2 In this context, it is surprising to see that there is a striking gap between

two strands of the corporate finance literature. While the literature on optimal capital

structure (see e.g. Kraus and Litzenberger 1973; Leland 1994 for a continous-time

version) has been accounting for default risk and bankruptcy costs for decades, these

features have not been included in the typical DCF approaches yet. For this reason, it is

desirable to impose extensions to the standard DCF framework that allow for a consistent

treatment of default risk without sacrificing the tractable pricing structure.

In this paper, we extend the standard WACC firm valuation approach for default risk

and bankruptcy costs. Fortunately, the resulting WACC discount rate, that is used to

discount the unlevered cash flows of the firm, keeps its simple structure. The only

adjustments refer to the periodic default probability and the relative bankruptcy costs. Due

to historic data about prior defaults, reasonable proxies for these two required variables can

easily be obtained. Moreover, we show in a practical application that the WACC discount

rate for firms with default risk can substantially differ from the naive WACC discount rate

that ignores default risk.

The paper is organized as follows: In Sect. 2, we derive how to adjust the WACC

discount rate for default risk and bankruptcy costs so that in line with the traditional

WACC approach firm values of default-risky firms with bankruptcy costs still result from

the discounted unlevered cash flows. Section 3 highlights the practical relevance of the

pricing effect from default risk. Section 4 concludes. The technical development of a multistate WACC formula is in Appendix.

More recent papers about tax shields and bankruptcy costs are Fich and Slezak (2008), Baez-Daz and

Alam (2012), and Couch et al. (2012).

Noteworthy exceptions for DCF approaches dealing with bankruptcy are Cooper and Nyborg (2008),

Molnar and Nyborg (2012). In these approaches the tax shield consequences for defaultable debt are

quantified. However, the explicit default probability and bankruptcy costs are not considered and the

resulting discount rate does not exhibit a tractable form.

123

654

C. Koziol

discussions: Some authors address common misunderstandings of DCF pricing and show

how to correctly deal with it (see e.g. Inselbag and Kaufold 1997; Graham 2001; Booth

2002; Cooper and Nyborg 2007; Laughton et al. 2008).

Despite the ongoing discussions, there is still one fundamental drawback in the DCF

framework. This shortcoming refers to firms default risk which is typically not taken

into account by the DCF methods. Standard DCF models implicitly assume that tax

shields will arise until the end of the firms planning horizon. Apparently, once a default

takes place, the tax shields, which can attribute to a considerable part of the firm value

(see Graham 2001), are strongly affected. Moreover, a firm exhibits various direct and

indirect costs during a default process.1 Examples for these costs are expenses for

lawyers and consultants (direct bankruptcy costs) as well as the costs that important

managers and employees must care for issues different from their core business and

might consider outside job offers, and the loss of reputation and trust (indirect bankruptcy costs) etc. As a consequence, all these relevant costs in the case of bankruptcy

cannot be taken into account when pricing models such as the DCF approach disregard

default risk. Hence, default is a major issue for the firm value, as in the case of a default

tax shields are reduced or disappear and the firm suffers from additional losses (bankruptcy costs).2 In this context, it is surprising to see that there is a striking gap between

two strands of the corporate finance literature. While the literature on optimal capital

structure (see e.g. Kraus and Litzenberger 1973; Leland 1994 for a continous-time

version) has been accounting for default risk and bankruptcy costs for decades, these

features have not been included in the typical DCF approaches yet. For this reason, it is

desirable to impose extensions to the standard DCF framework that allow for a consistent

treatment of default risk without sacrificing the tractable pricing structure.

In this paper, we extend the standard WACC firm valuation approach for default risk

and bankruptcy costs. Fortunately, the resulting WACC discount rate, that is used to

discount the unlevered cash flows of the firm, keeps its simple structure. The only

adjustments refer to the periodic default probability and the relative bankruptcy costs. Due

to historic data about prior defaults, reasonable proxies for these two required variables can

easily be obtained. Moreover, we show in a practical application that the WACC discount

rate for firms with default risk can substantially differ from the naive WACC discount rate

that ignores default risk.

The paper is organized as follows: In Sect. 2, we derive how to adjust the WACC

discount rate for default risk and bankruptcy costs so that in line with the traditional

WACC approach firm values of default-risky firms with bankruptcy costs still result from

the discounted unlevered cash flows. Section 3 highlights the practical relevance of the

pricing effect from default risk. Section 4 concludes. The technical development of a multistate WACC formula is in Appendix.

More recent papers about tax shields and bankruptcy costs are Fich and Slezak (2008), Baez-Daz and

Alam (2012), and Couch et al. (2012).

Noteworthy exceptions for DCF approaches dealing with bankruptcy are Cooper and Nyborg (2008),

Molnar and Nyborg (2012). In these approaches the tax shield consequences for defaultable debt are

quantified. However, the explicit default probability and bankruptcy costs are not considered and the

resulting discount rate does not exhibit a tractable form.

123

655

2.1 Standard approach without default risk

The classical WACC valuation is a simple and intuitive approach to determining the

present value of a company accounting for tax benefits as a result of the tax deductibility of

interest payments. Once the after-tax weighted average cost of capital WACC is given, the

WACC approach provides the value Vt of a firm at time t by discounting the expected aftertax free cash flows Et Xts of a firm in all future dates t ? s with s = 1, , T in the

following well-known way:

Vt

T

X

s1

Et Xts

:

1 WACC s

The operator Et indicates the expectation conditional to the information available at the

current date t. Note that the cash flow Xt?s at time t ? s is not the free cash flow after tax of

the levered firm but it refers to the free cash flow net of taxes of an otherwise identical but

unlevered firm. Ruback (2002) emphasizes this aspect by distinguishing between the

unlevered cash flows and the capital cash flows. The capital cash flows (or equivalently

cash flows of a levered firm) are the total amount of cash that can be paid out to all

investors, i.e. equity and debt holders in this case. Formally, the capital cash flows comprise of the free cash flows Xt?s of an unlevered firm net of tax plus the tax benefits

obtained at time t ? s:

Xts s Dts1 c;

where s denotes the corporate tax rate. Dt?s-1 stands for the value of defaultfree debt in the

previous period t ? s - 1 and c is the nominal interest rate of debt. Thus, the product of

the debt value Dt?s-1 and the interest rate c yields the total interest payment due at date

t ? s. To have a simple notation, we focus on corporate taxes only and abstract from

personal taxes that might concern equity and debt holders. Due to the absence of default

risk, we consider the promised interest rate c on debt to be equal to the cost of debt kD

which coincide with the risk-free rate rf.

At first glance it might be surprising that the WACC approach does not consider the true

expected cash flows of the firm but only the expected cash flows net of tax shields. The

reason for this is that the tax shields are endogenously captured by the choice of

the discount rate WACC. Miles and Ezzell (1980) show that the WACC approach results in the

same firm value Vt as the at first glance more intuitive approach which discounts the total

expected cash flows at the company cost of capital kV. This result holds for the assumptions

that the debt ratio DV and costs of capital, i.e. cost of equity kE and cost of debt kD = rf, are

constant during the firms lifetime from t to t ? T.3 The intuitive way to represent the firm

value as a function of the stochastic future cash flows Xt?s, s = 1, 2, , T is as follows:

T

T

X

Et Xts s Vts1 DV kD

Et Xts s Dts1 kD X

Vt

;

2

1 kV s

1 kV s

s1

s1

where the discount rate kV is the (deterministic) expected return of the firm Vt (company

cost of capital). Representing the firm by a portfolio which consists of equity with a

3

Moosa and Li (2012) provide empirical determinants of firms capital structure choice.

123

656

C. Koziol

portfolio weight equal to the equity ratio VE and debt with a weight equal to the debt ratio

D

E

V 1 V ; we directly obtain the company cost of capital kV from the cost (expected

return) of equity kE and debt kD:

kV

E

D

kE kD :

V

V

This representation illustrates for why the company cost of capital kV are also denoted as

(pre-tax) WACC, because the cost of both equity and debt are weighted by the corresponding equity or debt ratio, respectively. Since the WACC approach (1) considers lower

expected cash flows than the intuitive approach (2), the WACC discount rate WACC must

differ from the company cost of capital kV (pre-tax WACC) in order to yield the same firm

value Vt. Following Miles and Ezzell (1980), the consistent WACC discount rate, that

ensures an identical firm value Vt as with the intuitive approach, is given by:

E

D

kE kD 1 s

V

V

D

kV kD s

V

WACC

As a result, the discount rate WACC coincides with the pre-tax WACC except for the only

difference that the cost of debt kD are multiplied by the after tax factor 1 - s. For this reason,

the discount rate WACC is typically denoted as the after tax WACC in contrast to the

company cost of capital kV, which are interpreted as the pre-tax WACC. In comparison to

(2), the WACC approach captures the tax shields in form of an adjustment of the discount rate

WACC. Hence, the advantage of the WACC approach is that a simple correction of the

discount rate WACC is sufficient to obtain the value of a levered firm by discounting

the unlevered cash flows. The general approach (2), however, requires knowledge of the

expected value of the firm in the future, which implies a more sophisticated computation.

2.2 Extended WACC approach with default risk

A crucial assumption implicitly imposed by the standard DCF methods is that the considered firms are not subject to default risk even though they have debt outstanding. The

fact that firms have debt in their capital structure, however, introduces the possibility that

firms might not be able to fully satisfy the promised payments of the debt contract which

causes a default. To deal with this apparent contradiction that, on the one side, firms have

debt and are, on the other side, default risk-free, we introduce a DCF method that explicitly

accounts for default risk. Our goal is to enrich the typical WACC framework so that we can

still apply the tractable, well-known WACC valuation formula (1) for default-risky firms.

Since the expected cash flows of an unlevered firm are exogenously given, the impact from

default risk on the value of a levered firm must be captured by the size of the endogenous

discount rate WACC. Therefore, we want to find a simple correction for the discount rate

WACC that allows for a consistent pricing under default risk and bankruptcy costs.

A standard approach proposed by the literature to tackle default risk is to capture the

possibility of a default by a risk correction for the cost of debt (see e.g. Ruback 2002;

Farber et al. 2005; Cooper and Nyborg 2006; Oded and Michel 2007). However, this

approach has two important drawbacks. First, it does not explicitly model the default event;

for example tax benefits are considered to arise in the future independent of the fact

whether a prior default occurs or not. Second, a higher leverage and higher risk-adjusted

123

657

cost of debt will typically result in higher interest rate payments which increase tax shields.

In particular, representation (4) reveals that the after-tax WACC declines in the leverage DV

and the cost of debt kD once the company cost of capital kV are given. This property implies

the counter-intuitive effect that firms can add firm value with a higher debt ratio. This

relationship, however, ignores potential negative effects associated with debt. For this

reason, we will explicitly consider bankruptcy costs as a simple device to capture the

negative effects on the firm value when firms have debt outstanding.

As a consequence of potential defaults, we must distinguish between the value of a

solvent and insolvent firm. The value Vt of a levered firm now refers to a solvent firm rather

than to an insolvent one. For a firm that is subject to a default, however, its value corresponds to the value without a default net of bankruptcy costs. As usual, we can think of

default as an event that additionally hurts the firm value compared to the case that the

identical firm would not have to file for bankruptcy.

For the following analysis, we consider the typical structural assumptions associated

with the WACC approach namely that the debt ratio of the firm as well as the cost of equity

kE, the cost of debt kD, the company cost of capital kV of a levered firm, and the riskfree

rate rf are constant over time. As a consequence of this corporate financial policy, we

assume that from the perspective of any state at an arbitrary date t, in which the firm is

solvent, there is a unique probability p for remaining solvent until the subsequent period

t ? 1. Accordingly, the one-period default probability for a solvent firm in any state and at

any date is 1 - p which refers to a typical reduced-form default concept. Figure 1

123

658

C. Koziol

illustrates the model framework for a representative state in which the firm is solvent at an

arbitrary date t.

In the case of no default nod in the subsequent period t ? 1, the firm benefits from the

tax advantage equal to s DV Vt c; where in the event of a default def the tax benefits

disappear. As a result of default risk, the interest rate c is a promised interest rate that is not

paid with certainty.4 It can be easily adjusted to other tax obligations in the case of default

in an analogous way. Additionally, in the case of default at time t ? 1, bankruptcy costs

a Vt incur which are proportionate to the value of a solvent firm at the preceeding period

t. Consequently, in the case of a default the claimants can split up a total wealth

Vt1 a Vt equal to firm value without a default minus bankruptcy costs. At first glance,

it might not be reasonable to relate the bankruptcy costs at time t ? 1 to the firm value Vt at

the preceeding period t. In general, once the expected return of the firm value in advance to

a default is known, the relative bankruptcy costs a can easily be translated into a fraction of

the current firm value at time t ? 1. However, with regard to the discount rate WACC that

we are going to derive, the decision to describe bankruptcy costs as a fraction of the

preceeding firm value results in a more elegant formula.

With this explicit modelling of the default event we have the following: After a default

at t ? 1, the debt holders obtain the firm value Vt1 a Vt 0 net of bankruptcy costs

and the equity holders are left with nothing. Then, the debt holders either liquidate the firm

to receive the value of the insolvent firm in cash or (given that this alternative is not

feasible) keep the firm alive. Keeping the firm alive, however, requires that capital equal to

the bankruptcy costs is injected. After the injection of new capital, the capital structure of

the saved firm will be restructured to maintain the given debt ratio DV : One possibility to

accomplish this restructuring is to issue the appropriate amount of equity and debt to new

investors. As a consequence, this model setup is flexible enough to deal with both outcomes from a default process, liquidation and restructuring.

To allow for the fact that a firm in the case of a default is less successful than without a

default, we consider expectations conditional to a default or no default, respectively. It is

plausible to assume that the conditionally expected unlevered cash flow Et Xt1 jnod in

the case nod that no default takes place exceeds the conditionally expected unlevered cash

flow Et Xt1 jdef for the default case def. The conditional expectations are just a helpful

tool to derive a tractable pricing formula. The particular knowledge of the conditional

expectations will not be required when computing firm values but only the usual

(unconditional) expectation. The same relationship is true for the firm value:

Et Xt1 jnod [ Et Xt1 jdef ;

Et Vt1 jnod [ Et Vt1 jdef :

Note that this treatment of the default and no default case does not mean that there are only

two possible states at date t ? 1. Rather, there can be arbitrarily many states with different

levels of unlevered cash flows for both events. The only implicit restriction behind this two

state approach is that the firm either survives and enjoys full tax shields or defaults.

Apparently, it is thinkable that the firm does not default but due to a loss does not benefit

from the full amount of tax deductions from interest expenses. For this reason, we regard a

The nominal interest rate c might contain a risk premium for default risk and bankruptcy costs. However,

regardless of the size of c, the company cost of capital kV within the DCF approach ensure a consistent

pricing of the firm value (see Fernandez (2012), topic 3) for the treatment of nominal interest rates.

123

659

multi-state approach in Appendix. In this technically more sophisticated case, a structurally equivalent WACC formula for default risk and bankruptcy costs is obtained.

The conditional expectations and the survivorship probability p allow us to compute the

expectations of unlevered cash flow net of tax and the expected firm values that are

required for a typical WACC valuation.

According to the law of conditional expectations, we can write:

Et Vt1 p Et Vt1 jnod 1 p Et Vt1 jdef ;

Et Xt1 p Et Xt1 jnod 1 p Et Xt1 jdef :

In what follows, we derive the default-risk-adjusted WACC, that justifies the application of

the general WACC approach as in (1), but where the discount rate WACC still accounts for

default risk and bankruptcy costs. For this purpose, we consider two representations that

describe the relationship between the firm value Vt on the one side and the sum out of the

expected firm value and free cash flows in the subsequent period on the other side. From

the construction of the WACC approach in (1), we obtain the following term for the firm

value increased by the WACC discount rate:

Vt 1 WACC Et Vt 1 WACC

Et

T

X

Et1 Xts

s1

1 WACC s1

Et Xt1

T

X

Et1 Xts

s2

1 WACC s1

!

:

Making use of the fact that the firm value at time t ? 1 is:

Vt1

T

X

Et1 Xts

s2

1 WACC s1

and applying the law of iterated expectations, we obtain the first useful relation:

Vt 1 WACC Et Xt1 Et Vt1

The second useful relation follows from the expected wealth Vt 1 kV from an

investment into the firm for a one-period investment. Due to constant cost of capital in any

arbitrary period, the expected wealth from a one-period investment into the firm

accounting for tax benefits and bankruptcy costs is given by:

D

Vt 1 kV p Et Xt1 jnod Et Vt1 jnod s Vt c

V

6

1 p Et Xt1 jdef Et Vt1 jdef a Vt

Et Xt1 Et Vt1 p s

D

Vt c 1 p a Vt :

V

The expected revenues from a one-period investment in the firm come from the (with the

survivorship probability p) weighted revenues in the solvency case consisting of the

unlevered cash flows, the firm value, and the tax shields as well as the (with the default

probability 1 - p) weighted outcome in the case of default comprising out of unlevered

cash flows, the firm value, and bankruptcy costs.

123

660

C. Koziol

Now, we can simplify the two useful Eqs. (5) and (6) to get a representation for the

discount rate WACC after tax, default risk, and bankruptcy costs dependent on the pre-tax

WACC kV. The adjusted WACC discount rate reads:

D

c 1 p a

V

E

D

D

kE kD p s c 1 p a

V

V

V

WACC kV p s

The second line is a result of the fact that like in the case without default risk, the company

cost of capital kV can be substituted by the pre-tax weighted average cost of capital

E

D

V kE V kD :

This important equation for WACC with default risk shows that we can represent the

discount rate WACC by the pre-tax cost of capital kV of the firm plus a correction for tax

benefits and a further correction for bankruptcy costs. Comparing this formula for the

WACC to the case without default risk (4), we find that the tax component s DV c for given

leverage DV and interest rate c declines because it is weighted with the one-period nondefault probability p. Moreover, the discount rate WACC rises with expected relative

bankruptcy costs 1 p a: Hence, we can still use the standard WACC approach, which

bases on a framework without default risk, when computing the discount rate WACC with

regard to default risk and bankruptcy costs. The WACC discount rate has an equivalent

structure as in the more general multi-state case, which also allows for the partial use of tax

shields, carried out in Appendix. In line with the WACC formula from the appendix in

Eq. (8), the tax shields are the typical tax shields term weighted with the expected level of

effective tax shields. Accordingly the bankruptcy costs are treated.5 Apparently, the default

risk and bankruptcy costs adjustments increase the WACC for given cost of capital kV. This

is intuitive because the described default risk together with bankruptcy costs negatively

affects the firm value, where the firm value strictly declines with WACC.

In what follows, we evaluate the impact of default risk and bankruptcy costs for the

discount rate WACC and therefore for the firm value. In order to illustrate this impact, we

consider a typical non-investment grade firm. According to Standard & Poors (2009), BB

rated companies have exhibited a historic, 1-year default frequency equal to 0.99 %, while

B and C rated firms have shown a higher default frequency equal to 4.51 and 25.67 %,

respectively. To have a conservative proxy for the 1-year survivorship probability, we

choose p = 0.98 which corresponds to a periodic default probability equal to 2 %.

The estimation of the additionally required bankruptcy costs is a challenging task that

has concerned several academics. The spectrum of proposed bankruptcy costs ranges from

about 5 % as suggested by Warner (1977) and Ang et al. (1982), who focus on direct

bankruptcy costs, up to 20 % as documented by Andrade and Kaplan (1998). However,

Andrade and Kaplan still argue that bankruptcy costs strongly differ across firms so that it

is not unlikely for firms having even much higher bankruptcy costs. To have an economically significant size of bankruptcy costs that is still realistic for some firms, we take

5

In the case in which only a default and a survivorship with full use of tax shields occurs, the expected level

of tax shields is equal to the survivorship probability p and the expected level of bankruptcy costs equal to

the default probability 1 - p.

123

661

this level a = 0.2 as a starting point and keep in mind that the bankruptcy costs might

attain values which can be even higher or lower.

Moreover, we set the debt ratio DV of the firm equal to 80 % which refers to a typical

non-financial firm. The corporate tax rate s is 35 %. Finally, the company cost of capital kV

and the nominal interest of debt c are fixed at 10 and 5 %, respectively.

The parameter values of the initial firm are summarized below:

Bankruptcy costs a = 0.20,

Debt ratio DV 0:80;

Tax rate s = 0.35,

Company cost of capital (pre-tax WACC) kV = 0.10 of a levered firm,

Nominal interest rate c = 0.05 of debt.

To differentiate between the WACC discount rates (and the corresponding firm values)

with and without accounting for default risk, we add a superscript (C) for the correct values

with regard to default risk modeling and the superscript (W) for the wrong values ignoring

default risk.

In this example, the traditional WACC approach (4) for the case without default risk

amounts to the following discount rate WACC(W):

WACC W 0:10 0:35 0:80 0:05 8:60 %:

Regarding the consequences from bankruptcy costs and default risk, the adjusted WACC(C)

from representation (7) is

WACC C 0:10 0:98 0:35 0:80 0:05 0:02 0:20 9:03 %:

This example reveals that an application of the traditional WACC approach ignoring

default risk can result in a discount rate WACC(W) that underestimates the correct rate

WACC(C) by 43 basis points. To quantify the relevance of the gap between the discount

rates, we approximate in how far this difference carries forward to a wrong pricing of the

firm value. For this purpose, we consider a firm with perpetual expected unlevered cash

flows after tax equal to 100 units in every period. Thus, the firm value simplifies to

V0

100

:

WACC

The relative difference in percentage terms between the consideration of the correct firm

C

100

100

value V0 WACC

WACC

C and the wrong firm value V0

W that erroneously regards the

(W)

discount rate WACC without the appropriate adjustments for default risk and bankruptcy

costs amounts to:

W

pricing error

V0

C

V0

100

1 WACC

100

1

WACC C

WACC C

1:

WACC W

This meaningful representation documents that the relative difference of the discount rates

WACCC

WACCW

V0

V0

In the considered example, the relative difference between the true WACC(C) and the

wrong discount rate WACC(W) and therefore also the resulting firm value pricing error

amounts to

123

662

C. Koziol

This numerical illustration shows that the default risk correction is a relevant factor for

practical firm valuation purposes. Given various sources of uncertainty involved in the firm

valuation process, a deviation of about 5 %, however, is not dramatic.

In the remainder of this section, we want to figure out which factors result in high

pricing errors when applying the wrong WACC approach and under which conditions the

traditional approach without default risk can still be justified.

Table 1 varies the debt ratio of the considered firm. The debt ratio is an important factor

for the tax shields. Due to default risk, the tax shields are reduced which may be one reason

for the pricing error. Based on our initial example, we vary the debt ratio DV in its feasible

range from 0 to 100 %. As usual for comparative static analyses, we keep the other

parameter values constant in order to separate between the real drivers of the relevant

effects. This approach, however, implies that the debt ratio does not affect the default

probability 1 - p as p is fixed in Table 1; we will regard different default probabilities in

Table 3.

According to Table 1, there is already a considerable pricing error for unlevered firms

equal to 4 %. This pricing error is a result of the fact that the textbook WACC framework

disregards bankruptcy costs. Then, the pricing error rises from 4 to 5.3 % when the debt

ratio increases from 0 to 100 %. Hence, we can conclude that due to a mispricing of the tax

shields, the pricing error increases with the debt ratio, but a higher debt ratio does not

strongly increase the pricing error.

In the next step, we regard the impact of the bankruptcy costs. Depending on the

business, almost the total firm value can be saved in some businesses such as in the hotel

business because transferring assets to another company does not result in substantial

losses. However, there are also other industries such as service oriented businesses where

the value primarily comes from the know-how of the employees. Since in the case of a

default process, a huge part of human capital is lost, the bankruptcy costs in these cases can

be close to the total firm value before a default. As bankruptcy costs can cause severe

losses in the default event, they might be a relevant driver for differences between the

classical WACC firm value and the WACC approach adjusted for default risk.

Table 2 shows the WACC discount rates and the pricing error for our standard example

when the bankruptcy costs a are varied from 0 to 50 %. According to Table 2, the pricing

error is negligible if in the case of a default no bankruptcy costs a = 0 incur. For relatively

high bankruptcy costs a = 0.5, the pricing error can easily exceed 10 %. Thus, the

bankruptcy costs are a first important factor for the choice of the WACC method.

In the third step, we regard the impact of the survivorship/default probability. For this

purpose, we allow for a range of survivorship probabilities from 90 to 100 % in our

and pricing errors of firm values

depending on debt ratio

123

D/V (%)

WACC(W) (%)

WACC(C) (%)

10.00

10.40

4.00

20

9.65

10.06

4.22

40

9.30

9.71

4.45

60

8.95

9.37

4.70

80

8.60

9.03

4.98

100

8.25

8.69

5.27

Table 2 WACC discount rates

and pricing errors of firm values

depending on bankruptcy costs

663

a (%)

WACC(W) (%)

WACC(C) (%)

8.60

8.63

0.33

10

8.60

8.83

2.65

20

8.60

9.03

4.98

30

8.60

9.23

7.30

40

8.60

9.43

9.63

50

8.60

9.63

11.95

Table 3 WACC discount rates and pricing errors of firm values depending on default probability

p (%)

WACC(W) (%)

WACC(C) (%)

100

8.60

8.60

0.00

98

8.60

9.03

4.98

96

8.60

9.46

9.95

94

8.60

9.88

14.93

92

8.60

10.31

19.91

90

8.60

10.74

24.88

AA rating, while a one-period survivorship probability of 90 % (default probability equal

to 10 %) is consistent with a rating between B and CCC. Clearly, the survivorship probability determines how likely a default is so that it is supposed to be a potentially relevant

factor for differences between firm values from the WACC approach with and without

default risk. Table 3 remarkably shows that the survivorship probability is a major factor

for the pricing error of the firm value. Without default risk, i.e. p = 1, the classical WACC

approach results in the correct firm value. When default risk, however, is severe such as for

a relatively low survivorship probability p = 0.9, the pricing error can increase to a

remarkable level of about 25 %.

As a result, both the default probability and the bankruptcy costs are major factors for

the firm value under default risk. Every single factor can already result in strong pricing

errors between 10 and 25 %. To get an impression about the total pricing error when both

factors are modified, we report the pricing error from our standard example for various

parameter values of bankruptcy costs and survivorship probabilities in Table 4. This table

reveals that a simultaneous consideration of the default probability and the bankruptcy

costs is necessary. If both the default risk is low (survivorship probability is close to

100 %) and there are only minor losses in the case of default (bankruptcy costs are close to

zero), there are almost no pricing differences between the outcomes from the two WACC

alternatives so that the traditional WACC approach can be fully justified. If, however, the

considered firm has a relatively high default probability and is from an industry with

relatively high losses in the case of bankruptcy, then the pricing errors are huge. Table 4

documents pricing errors higher than 50 %. As a result, for those firms knowledge of the

default probability and the bankruptcy costs are essential to have a reasonable pricing and

the advanced WACC approach for default risk must be applied.

123

664

C. Koziol

Table 4 Pricing errors of firm values depending on both default probability and bankruptcy costs

p (%)

a

0 (%)

10 (%)

20 (%)

30 (%)

40 (%)

50 (%)

100

0.00

0.00

0.00

0.00

0.00

0.00

98

0.33

2.65

4.98

7.30

9.63

11.95

96

0.65

5.30

9.95

14.60

19.26

23.91

94

0.98

7.95

14.93

21.91

28.88

35.86

92

1.30

10.60

19.91

29.21

38.51

47.81

90

1.63

13.26

24.88

36.51

48.14

59.77

4 Conclusion

Motivated from the observation that the standard DCF firm valuation methods only consider the advantages of debt in form of tax shields but disregard potential negative effects

of it, we aim at developing a tractable firm valuation model that accounts for the disadvantages of debt such as default risk and bankruptcy costs. Based on the famous WACC

framework, we show that simple and intuitive corrections are sufficient to determine a

discount factor WACC for the expected unlevered cash flows after tax in order to compute

the firm value with regard to tax effects, default risk, and bankruptcy costs. The representation of the new WACC coincides with the traditional discount factor WACC without

default risk, where the term for the tax shield needs to be weighted with the one-period

survivorship probability and a further term equal to the expected relative bankruptcy costs

must be added.

The good news about the traditional WACC discount rate without default risk is that in

many cases for which firms have a good rating about A or better and bankruptcy costs are

not severe, the classical WACC approach without correction for default risk can be fully

justified.

However, for non-investment grade firms, who would suffer from considerable bankruptcy costs, the default risk correction of the WACC is striking. In these cases, the true

WACC discount rate can exceed the standard textbook formula ignoring default risk by

more than 50 % which causes dangerously high pricing errors of firms.

To account for a very general case of tax shields, in which the firm does not default but

only obtains a part of the full tax shield, we can extend the model framework as follows:

Let the tax shields at time t ? 1:

/s s Dt c;

where /s 2 0; 1 denotes the fraction of the full tax shield s Dt c that is in effect at time

t ? 1. In the case of positive earnings, /s is obviously one, and in the case of a default in

which the tax deductions cannot be used, /s amounts to zero. In other cases, /s can take

values between zero and one which can be interpreted as a firm that is currently able to

satisfy its interest payments but does not have positive earnings in order to take full

advantage of their feasible tax shields. Hence, /s s Dt c is the present value of tax

123

665

shields that is obtained from carrying forward the tax deductions s Dt c to future periods.

Technically speaking, /s is a random variable from the perspective of time t and realizations are observed at time t ? 1. We impose the assumption that the distribution of the

realization of /s at time t ? 1 is known at time t. Hence, we no longer have two states in

which /s can only be zero or one but now we can incorporate arbitrarily many cases with

arbitrary distributions for /s.

We can apply a similar notion for the bankruptcy costs. Let us denote the bankruptcy

costs at time t ? 1 as:

/a a Vt ;

where /a denotes the fraction of bankruptcy costs that is in effect at time t ? 1. Apparently, without a default /a is zero and in the case of a default it amounts to one. However,

in the case of a reorganization, in which both outcomes a liquidation and a recovery are

thinkable, /a can be between zero and one. In line with the modelling of the discount factor

/s for tax shields, we also assume that the statistical distribution for /a is known one

period in advance.

When modifying Eq. (6) with the notation introduced in this appendix, we now obtain

for the expectation of total wealth from holding a firm alive at time t for one more period:

D

Vt 1 kV Et Xt1 Vt1 /s s Vt c /a a Vt

V

D

Et Xt1 Et Vt1 Et /s s Vt c Et /a a Vt :

V

The second equation is a straightforward consequence of the linearity of the expectation

operator Et : Combining this representation with the representation for the WACC discount factor in Eq. (5), we obtain:

WACC kV Et /s s

D

c Et /a a:

V

As a result, the WACC discount is the company cost of capital kV reduced by a tax shield

component and increased by a bankruptcy component. The tax shield term equals the wellknown term s DV c multiplied by the expected level Et /s : The same is true for the

bankruptcy term.

References

Andrade G, Kaplan S (1998) How costly is financial (not economic) distress? Evidence from highly

leveraged transactions. J Financ 53:14431493

Ang JS, Chua JH, McConnell JT (1982) The administrative costs bankruptcy: a note. J Financ 37:219226

Baez-Daz A, Alam P (2012) Tax conformity of earnings and the pricing of accruals. Forthcoming in Rev

Quant Financ Account

Booth L (2002) Finding value where none exists: pitfalls in using adjusted present value. J Appl Corp Financ

15 (95104)

Cooper IA, Nyborg KG (2006) Consistent methods of valuing companies by DCF: methods and assumptions. Working Paper

Cooper IA, Nyborg KG (2007) Valuing the debt tax shield. J Appl Corp Financ 19:5059

Cooper IA, Nyborg KG (2008) Tax-adjusted discount rates with investor taxes and risky debt. Financ Manag

37:365-379

123

666

C. Koziol

Couch R, Dothan M, Wu W (2012) Interest tax shields: a barrier options approach. Rev Quant Financ

Account 39:123-146

Farber A, Gillet R, Szafarz A (2005) A general formula of the WACC. Working Paper

Fernandez P (2012) Ten badly explained topics in most corporate finance books. Working Paper

Fich EM, Slezak SL (2008) Can corporate governance save distressed firms from bankruptcy? An empirical

analysis. Rev Quant Financ Account 30:225251

Graham J (2001) Estimating the tax benefits of debt. J Appl Corp Financ 14:4254

Inselbag I, Kaufold H (1997) Two DCF approaches for valuing companies under alternative financing

strategies (and how to choose between them). J Appl Corp Financ 10:114122

Kraus A, Litzenberger RH (1973) A state-preference model of optimal financial leverage. J Financ

28:911922

Laughton D, Guerrero R, Lessard D (2008) Real asset valuation: a back-to-basics approach. J Appl Corp

Financ 20:4665

Leland H (1994) Corporate debt value, bond covenants, and optimal capital structure. J Financ 49:1213

1252

Miles JA, Ezzell JR (1980) The weighted average cost of capital, perfect capital markets, and project life: a

clarification. J Financ Quant Anal 15:719730

Modigliani F, Miller MH (1963) Corporate income taxes and the cost of capital: a correction. Am Econ Rev

53:433-443

Molnar P, Nyborg KG (2012) Tax-adjusted discount rates: a general formula under constant leverage ratios.

Eur Financ Manag (Forthcoming)

Moosa I, Li L (2012) Firm-specific factors as determinants of capital structure: evidence from Indonesia.

Rev Pac Basin Financ Mark Pol 15:1150007-1150001-1150007-1150017

Myers SC (1974) Interactions of corporate financing and investment decisions: implications for capital

budgeting. J Financ 29:125

Oded J, Michel A (2007) Reconciling DCF valuation methodologies. J Appl Financ 17:2140

Ruback RS (2002) Capital cash flows: a simple approach to valuing risky cash flows. Financ Manag

31:85103

Standard & Poors (2009) 2008 Annual global corporate default study and rating transitions

Wang AT, Yang S-Y (2007) A simplified firm value-based risky discount bond pricing model. Rev Pac

Basin Financ Mark Pol 10:445468

Warner JB (1977) Bankruptcy costs: some evidence. J Financ 32:337347

123

## Mult mai mult decât documente.

Descoperiți tot ce are Scribd de oferit, inclusiv cărți și cărți audio de la editori majori.

Anulați oricând.