When a firm's default risk increases, the cost of debt obviously rises, which increases the WACC and decreases firm value. However, what happens to the cost of equity in this case? Has the proportion of debt in the firm's capital structure fallen (the value of debt has fallen)? This does not make much sense. Is it the case that expected cash flows to equity and therefore equity betas have changed, and the value of both equity and debt has fallen? Is default risk somehow reflected in equity beta (in some other way that is not the weight of debt, which says nothing about how risky that debt is)?
It is often said that WACC starts increasing at some point with leverage as a result of the costs of financial distress. Given that these are costs, wouldn't it be more accurate to account for them in expected cash flows rather than the WACC? When WACC is said to increase as a result of these costs, is it the increase in the cost of debt or also the increase in the cost of equity? Or does the systematic risk of cash flows increase, hence increasing betas (of equity and debt)? In other words, expected cash flows decrease and the cost of capital increases. This is not double counting of risks in my view, but rather the possibility of calculating betas from cash flows.
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