Cost of Capital for Equity Holders and Related Credit Risk

The purpose of this research is to understand the relation among the cost of capital, the cost of equity, the cost of debt, and the credit risk premium by using Leland model (1996). And empirical test is performed about how a bankruptcy risk premium should be shown in the actual Japanese market. It is assumed that there are no taxes throughout this paper. The firm value, the equity value and the debt value can be computed in consideration of the bankruptcy from the Leland model. To calculate a bankruptcy risk premium, it is necessary to formulate the relation between the cost and the value. In this research, it is also assumed that the stochastic process of firm value can be derived from the stochastic process of the cash flow, and a cash flow discount model is used to evaluate the firm value.

By this formulation, the bankruptcy risk premiums are calculated as the spreads between the costs when there is no bankruptcy and those when there are bankruptcies. In the Japanese market, when debt ratio (debt/asset) exceeds 70%, the bankruptcy risk premium rises rapidly under certain assumptions. With the debt ratio of 80%, the cost, of equity is about 20% and the bankruptcy risk premium within the cost of equity is about 10%. Our empirical result matches our experience.