Weighted Average Cost of Capital (Wacc) with Risky Debt: A Simple Exposition (I)

19 Pages Posted: 18 Nov 2002

See all articles by Joseph Tham

Joseph Tham

Educational Independent Consultant

Date Written: October 2002

Abstract

Debt is rarely risk-free. Yet, on grounds of simplicity, in most discussions on the weighted average cost of capital (WACC), we assume that the debt is risk-free. At the same, in the calculation of the WACC, we may use a value for the cost of debt d that is higher than the risk-free rate rf.

In this teaching note, using simple binomial models, we examine the weighted average cost of capital (WACC) with risky debt and no taxes. Taxes raise additional complications. In a subsequent note, we analyze the case with taxes. With risky debt, we have to use the expected rate of return on the debt rather than the promised rate of return on the debt in the formula for the WACC. Furthermore, we model the expected cost of risky debt as an increasing function of the amount of debt.

Keywords: multi-period WACC, cost of capital, risky debt

JEL Classification: D61, H43, G31

Suggested Citation

Tham, Joseph, Weighted Average Cost of Capital (Wacc) with Risky Debt: A Simple Exposition (I) (October 2002). Available at SSRN: https://ssrn.com/abstract=340100 or http://dx.doi.org/10.2139/ssrn.340100

Joseph Tham (Contact Author)

Educational Independent Consultant ( email )

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