The Relationship between Default Risk, Size and Financial Performance from Korean Firms

Studies of factors affecting the expected equity returns have long been a theme in capital market research. Contrary to theoretical predictions, it is argued that realized returns are too noisy to detect the true relation between default risk and expected returns. Therefore, this study uses the weighted average cost of capital (WACC) as a proxy of expected return. This study hypothesizes that the WACC has decreased the redemption of outstanding debt, but the financial performance is positively related to the outstanding debt as a alternative variable of default risk, using Korean firms during 2001-2010 period. The empirical results indicate that the WACC would be smaller for the period subsequent to a capital structure change than for the period the change, when outstanding debt is retired. Overall, these findings provide evidence in support of the hypothesis that the firm's value is a negative function of the firm's default risk as measured by the redemption of outstanding debt.