Research ArticleOpen AccessGoogle Scholar indexed
Pricing the Idiosyncratic Risk in the Cost of Capital: A Comprehensive Model
Department of Management, Ca’ Foscari University, Venice, Italy
Department of Management, Ca’ Foscari University, Venice, Italy
- 1 Department of Management, Ca’ Foscari University, Venice, Italy
- 2 Department of Management, Ca’ Foscari University, Venice, Italy
Theoretical Economics Letters·Volume 12 (2022)·Pages 1221–1226·Published 8 September 2022·DOI10.4236/tel.2022.125065
Copy link · social · email
Abstract
Despite the mixed evidence, recent empirical works highlight the importance of idiosyncratic risk in the stock market. On this basis, this note elaborates an approach to price directly the specific risk in the cost of capital, both for scientific empirical purposes and practitioner’s investment valuation. For extremely high leverage values, the cost of risky debt tends to approximate the unlevered cost of capital. Exploiting a Merton model, we show a simple solution to calculate in practice every cost of capital version, providing a comprehensive framework. A worked example is provided to simplify the concrete application.
KeywordsIdiosyncratic RiskLeveragePricingMerton ModelWACCValuation
- Baek, S., Mohanty, S. K., & Glambosky, M. (2020). COVID-19 and Stock Market Volatility: An Industry Level Analysis. Finance Research Letters, 37, Article ID: 101748. https://doi.org/10.1016/j.frl.2020.101748
- Begin, J. F., Dorion, C., & Gauthier, G. (2020). Idiosyncratic Jump Risk Matters: Evidence from Equity Returns and Options. The Review of Financial Studies, 33, 155-211. https://doi.org/10.1093/rfs/hhz043
- Bozhkov, S., Lee, H., Sivarajah, U., Despoudi, S., & Nandy, M. (2020). Idiosyncratic Risk and the Cross-Section of Stock Returns: The Role of Mean-Reverting Idiosyncratic Volatility. Annals of Operations Research, 294, 419-452. https://doi.org/10.1007/s10479-018-2846-7
- Copeland, T. E., Weston, J. F., & Shastri, K. (2005). Financial Theory and Corporate Policy (Vol. 4). Pearson Addison Wesley.
- Goyal, A., & Santa-Clara, P. (2003). Idiosyncratic Risk Matters! The Journal of Finance, 58, 975-1007. https://doi.org/10.1111/1540-6261.00555
- Laghi, E., & Di Marcantonio, M. (2016). Beyond CAPM: Estimating the Cost of Equity Considering Idiosyncratic Risks. Quantitative Finance, 16, 1273-1296. https://doi.org/10.1080/14697688.2015.1124136
- Merton, R. C. (1974). On the Pricing of Corporate Debt: The Risk Structure of Interest Rates. The Journal of Finance, 29, 449-470. https://doi.org/10.1111/j.1540-6261.1974.tb03058.x
- Miles, J. A., & Ezzell, J. R. (1980). The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification. Journal of Financial and Quantitative Analysis, 15, 719-730. https://doi.org/10.2307/2330405
- Modigliani, F., & Miller, M. H. (1963). Corporate Income Taxes and the Cost of Capital: A Correction. The American Economic Review, 53, 433-443.
- Solomon, E. (1963). Leverage and the Cost of Capital. The Journal of Finance, 18, 273-279. https://doi.org/10.1111/j.1540-6261.1963.tb00723.x
- Turner, J. A. (2014). Teaching the Effects of Risky Debt and Financial Distress Costs Using Consistent Examples. Journal of Financial Education, 40, 114-139.
- Zhang, X. (2016). Income Smoothing, Idiosyncratic Risk & CEO Turnover. Journal of Mathematical Finance, 6, 1-13. https://doi.org/10.4236/jmf.2016.61001