Which of the following statements regarding a firm’s pretax cost of debt is accurate?

Question

BlackTom AI · Accepted Answer

The pretax cost of debt equals the current market yield to maturity (YTM) on the firm’s outstanding bonds.

1) Relevant knowledge points and concepts
- Pretax cost of debt: the required return investors demand on the company’s debt before considering tax effects.  
- Yield to maturity (YTM): the internal rate of return that equates the present value of a bond’s future coupon payments and principal to its current market price. YTM reflects current market conditions and expected total return to investors.  
- Current yield: annual coupon divided by current price; it ignores capital gains/losses and time value across remaining maturities, so it is not equivalent to YTM.  
- Coupon rate and original YTM: set at issuance and may differ from current market rates; they do not necessarily reflect current investor required return.

2) Step-by-step reasoning
- The firm’s cost of debt should reflect the return investors currently require, not historical coupon terms.  
- For each outstanding bond, compute its current YTM by solving: Price = Σ [Coupon / (1+r)^t] + Face / (1+r)^n for r (the YTM). That r is the appropriate pretax cost for that bond.  
- If multiple bonds exist, compute each bond’s market-value-weighted YTM to get the firm’s overall pretax cost of debt.

3) Example calculation (intermediate steps)
- Suppose face = $1,000, annual coupon = $60, price = $950, n = 10 years. Current yield = 60/950 = 6.3158%. Approximate YTM ≈ (Annual Interest + (Face − Price)/n) / ((Face + Price)/2) = (60 + 50/10) / 975 = 65 / 975 = 6.6667%. YTM > current yield and reflects capital gain to maturity, so YTM is the correct measure.

4) Why the correct answer is correct
- YTM captures the total return investors will earn given current price and remaining cash flows, so it represents the market’s required pretax return on the firm’s debt. Therefore the pretax cost of debt is based on current YTM of outstanding bonds.

5) Why other options are incorrect
- “Must be estimated as it cannot be directly observed”: incorrect because market prices allow direct YTM calculation.  
- “Equal to coupon rate on the latest bonds issued”: incorrect; coupon is contractual and may not equal current market rates.  
- “Based on the original yield to maturity on the latest bonds issued”: incorrect because original YTM is historical and may differ from current YTM.  
- “Equivalent to the average current yield on all outstanding bonds”: current yield is not the correct return measure (ignores capital gains/losses); averaging current yields is not the standard method.

6) Conclusion
- The correct statement is: “It is based on the current yield to maturity of the company's outstanding bonds.” This matches the provided answer.

Which of the following statements regarding a firm’s pretax cost of debt is accurate?单项选择题

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