Levered-Beta and Cost of Capital Sensitivities: An Experimental Investigation in Capital Structure

Abstract

Using US firms with over $5b market cap, this paper tests the impact of levered beta on the firm’s market value and optimal capital structure. Using the synthetic rating method in a recursive model, the paper shows the current and optimal weighted average cost of capital sensitivities as the firm’s market risk measured by beta changes. The paper shows that the change in the value of beta due to alternative leverage levels or other risk factors will alter the cost of capital insignificantly and has no impact on the optimal capital structure due to those firms’ extra-strong bond ratings. As a side-benefit of the synthetic rating method, one may also observe the market-level variables’ impacts on the cost of capital computations and the optimal debt ratio. The paper uses Disney Corporation to show how the synthetic rating methodology helps to disclose the sensitivities of hypothetical alternative leverages.