TITLE:
Pricing the Idiosyncratic Risk in the Cost of Capital: A Comprehensive Model
AUTHORS:
Federico Beltrame, Gianni Zorzi
KEYWORDS:
Idiosyncratic Risk, Leverage, Pricing, Merton Model, WACC, Valuation
JOURNAL NAME:
Theoretical Economics Letters,
Vol.12 No.5,
September
9,
2022
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.