Cost of capital adjusted for governance risk through a multiplicative model of expected returns

Abstract

This paper sets forth another contribution to the long standing debate over cost of capital, firstly by introducing a multiplicative model that translates the inner structure of the weighted average cost of capital rate and, secondly, adjusting such rate for governance risk. The conventional wisdom states that the cost of capital may be figured out by means of a weighted average of debt and capital. But this is a linear approximation only, which may bring about miscalculations, whereas the multiplicative model not only takes account of that linear approximation but also the joint outcome of expected costs of debt and stock, and their proportions in the capital structure. And finally, we factor into the cost of capital expression a rate of governance risk.