In considering the market-based approach to measuring credit risk, choose all statements that are correct: a) The Merton model is useful to price defaultable debt as long as the underlying company has exchange-traded stocks. b) In the Merton model, the only unknown parameter is the volatility of firm equity c) In the Merton model, the only unknown parameter is the volatility of firm value, which comprises equity and debt. d) CDS spreads cannot be used to imply default probabilities because recovery rates are variable
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
In considering the market-based approach to measuring credit risk, choose all statements that are correct:
a) The Merton model is useful to price defaultable debt as long as the underlying company has exchange-traded stocks.
b) In the Merton model, the only unknown parameter is the volatility of firm equity
c) In the Merton model, the only unknown parameter is the volatility of firm value, which comprises equity and debt.
d) CDS spreads cannot be used to imply default probabilities because recovery rates are variable
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