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Rev Quant Finan Acc (2014) 42:653666

DOI 10.1007/s11156-013-0356-x
ORIGINAL RESEARCH

A simple correction of the WACC discount rate


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

JEL Classification G12  G31  G33

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

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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.

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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.

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2 DCF firm valuation with the WACC approach


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.

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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

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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

Fig. 1 Structure of model framework

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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.

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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.

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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.

3 Practical relevance of default risk for the WACC discount rate


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.

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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:

Survivorship probability p = 0.98,


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

 1 coincides with the (relative) pricing error

V0

V0

 1 of the firm value.

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

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pricing error 0:0903=0:086  1 4:98 %:


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

Table 1 WACC discount rates


and pricing errors of firm values
depending on debt ratio

123

D/V (%)

WACC(W) (%)

WACC(C) (%)

Pricing error (%)

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

A simple correction of the WACC


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

Pricing error (%)

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

Pricing error (%)

standard example. A survivorship probability of nearly 100 %corresponds to an AAA or


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.

Appendix: WACC formula for multi-state case


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

A simple correction of the WACC

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.

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