Valuing firm’s financial flexibility under default risk and bankruptcy costs: a WACC based approach

Purpose The purpose of this paper is to present a model to value leveraged firms in the presence of default risk and bankruptcy costs under a flexible firm's debt structure. Design/methodology/approach The authors assume that the total debt of the ?rm is a combination of two debt components. The ?rst component is an active debt component which is assumed to be proportional to the ?rm's value. The second one is a passive predetermined risk-free debt component. The combination of the two debt categories makes the ?rm's capital structure more realistic and allows us to include flexibility into the ?rm's debt structure management. The ?rm's valuation is performed using the discounted cash flow technique based on the weighted average cost of capital (WACC) method. Findings The model can be used to define active debt management strategies that can induce the firm to deviate from its capital structure target in order to preserve debt capacity for future funding needs. The firm's valuation is performed by using the WACC method and a closed form valuation formula is provided. Such a formula can be used to value costs and benefits of financial flexibility. Originality/value To the authors knowledge, the approach the authors propose is the first attempt to build a valuation scheme that accounts for firm's financial flexibility under default risky debt and bankruptcy costs. Including financial flexibility, this model fills an important gap in the literature on this topic.