Suppose a firm currently pays 4% interest on its existing loans, while bonds issued by companies with the same credit rating are trading in the market at a yield to maturity (YTM) of 10%.

What is the most appropriate cost of debt to use when calculating the firm’s WACC?

Question

Suppose a firm currently pays 4% interest on its existing loans, while bonds issued by companies with the same credit rating are trading in the market at a yield to maturity (YTM) of 10%.

What is the most appropriate cost of debt to use when calculating the firm’s WACC?

BlackTom AI · Accepted Answer

Because WACC should reflect the firm’s current marginal (market) cost of borrowing, the appropriate cost of debt is the market yield on comparable-risk debt, not the historical coupon rate.

1. Relevant knowledge points and concepts
- WACC uses the required (market) returns for each financing source: cost of equity and cost of debt.  
- The marginal cost of debt is the yield investors demand today for debt with the firm’s credit risk.  
- A coupon rate (the 4% on existing loans) is a historical contract rate; it does not equal the current cost if market yields differ.  
- If WACC is computed after taxes, the after-tax cost of debt = market yield × (1 − tax rate). No tax rate is given here, so use the pre-tax market yield.

2. Step-by-step reasoning
- The market shows bonds of firms with the same credit rating yield 10% today. That yield is the return investors now require from similar-risk debt.  
- If the firm were to raise new debt (or the market revalues its debt), investors would require ~10%, so the firm’s marginal borrowing cost is 10%.  
- The existing 4% loans are locked-in past contracts; their coupon does not change the required return on new funds and therefore should not be used for WACC.

3. Calculations and intermediate demonstration
- Simple perpetuity illustration: assume a bond with face value $1,000 pays coupon 4% → annual coupon = $40. If the market yield is 10%, price = coupon / yield = 40 / 0.10 = $400. That price implies a 10% yield regardless of the coupon—showing yield (market cost) governs the cost of debt, not the coupon.  
- If after-tax cost were required and tax rate t were given, cost_debt_after_tax = 10% × (1 − t).

4. Why the correct answer is correct
- WACC needs the current required return on debt. The market YTM of 10% for same-credit bonds equals that required return. Thus 10% is the appropriate input.

5. Why other options are incorrect
- “Depends on the debt-to-value ratio.” Incorrect: D/V affects weights in WACC, not the cost rate on debt itself.  
- “4%.” Incorrect: 4% is the historical coupon on existing loans, not the current market cost for new borrowing.  
- “The average of 4% and 10%.” Incorrect: There is no reason to average a historical coupon and current market yield; WACC uses the current market rate.

6. Conclusion
The most appropriate cost of debt to use in the firm’s WACC is 10%, which matches the provided answer.

Suppose a firm currently pays 4% interest on its existing loans, while bonds issued by companies with the same credit rating are trading in the market at a yield to maturity (YTM) of 10%. What is the most appropriate cost of debt to use when calculating the firm’s WACC?单项选择题

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