Select the best method for determining the Cost of Debt among the following alternatives:

Question

BlackTom AI · Accepted Answer

Yield to maturity (YTM) on bonds with the same credit rating as the analyzed company is the most appropriate measure for the cost of debt.

1) Relevant knowledge points and concepts
- Cost of debt is the market-required return lenders demand for a firm’s debt; for WACC we usually use after-tax cost of debt: rd_after = rd_pre * (1 − Tc).
- YTM reflects the market rate that equates current bond prices to expected future cash flows and thus captures current market credit spreads, term structure, and default risk.
- Coupon rates and historical interest charges are contractual or past measures and do not necessarily represent the current market-required return. CAPM and equity beta measure cost of equity, not debt.

2) Step-by-step reasoning
- The goal is to estimate the current market yield demanded by lenders for debt of similar risk and maturity.
- Identify bonds issued by firms with the same credit rating and similar maturity. The observed YTM on those bonds is the market’s required pre-tax debt return for that credit risk.
- Convert the pre-tax YTM to after-tax cost by applying the corporate tax rate.

3) Calculation example (intermediate steps)
- Suppose comparable bonds’ YTM = 6.0% and corporate tax rate Tc = 30%.
- rd_after = 6.0% × (1 − 0.30) = 6.0% × 0.70 = 4.2%.

4) Why the correct answer is correct
- YTM on similarly rated bonds captures current market pricing, default risk and term premium, making it the best proxy for the firm’s marginal cost of debt.

5) Why other options are incorrect
- Company’s bond coupon rate: a contractual historical rate; may differ from current market yields.
- Company’s current interest expenditures: reflects past financing mix and principal amounts, not the marginal market rate.
- Equity’s beta and CAPM: estimates cost of equity, not debt—different risk characteristics and investors.

6) Conclusion
The best method is the YTM of bonds with the same credit rating as the analyzed company, which matches the provided correct answer.

Select the best method for determining the Cost of Debt among the following alternatives:单项选择题

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