After Modigliani, Miller, and Hamada: A new way to estimate cost of capital

Abstract

In this article, we discuss the impact of financial debt on shareholder value using a new approach that aims: (a) to explain the effect that leverage from debt has on a stock’s systematic risk, or what we shall call here “the systematic cost of leverage,” and (b) to account for default risk in the cost of equity, or what we shall call here “the cost of default.” Our assessment of systematic risk is based on a stochastic approach that is materially different from the one proposed by Hamada: the risk premium remunerates the investor for the probability of equity (expressed as market value) generating a return below that of the risk-free rate. Furthermore, the approach we use to account for default risk is derived from reduced-form models, but in this case, (a) we use real probabilities of default and not risk-neutral probabilities, and (b) we extend the approach to stocks.