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

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.