Pricing the Idiosyncratic Risk in the Cost of Capital: A Comprehensive Model

Despite the mixed evidence, recent empirical works highlight the importance of idiosyncratic risk in the stock market. On this basis, this note elaborates an approach to price directly the specific risk in the cost of capital, both for scientific empirical purposes and practitioner’s investment valuation. For ex- tremely high leverage values, the cost of risky debt tends to approximate the unlevered cost of capital. Exploiting a Merton model, we show a simple solu- tion to calculate in practice every cost of capital version, providing a compre- hensive framework. A worked example is provided to simplify the concrete application.