Cost Of Debt

The Cost of Debt
Ian Cooper¤ Sergei Davydenko

London Business School

First mutant: June 1998 This version: 8 March 2001

Abstract This paper proposes a practical way of estimating the represent of unstable debt for use in the cost of capital. The cost of debt is di®erent from both the promised yield and the risk-free rate, which argon sometimes used for this purpose, because of the judge hazard of omission. The Merton (1974) model of risky debt is employed to decompose the promised yield spread into expected default and return premium components. The advantage of the proposed approach is that all inputs atomic number 18 easily observable. The parameters of the Merton model implied by these inputs are used to number the expected return on debt. It is argued that, although Mertons framework is simple and stylised, it atomic number 50 be used to estimate the expected return as a fraction of the observed promised market yield in a way consistent with equilibrium. The cost of debt is computed for parameter set that are typical for high ordinate and low grade debt. It is found that, while using the promised yield as the cost of debt may be adequate for high grade debt, it is probable to cause signi¯cant errors for high-yield bonds. In such cases the approach proposed in this paper can be used to adjust the WACC for the probability of default on the ¯rms debt.





JEL Classi¯cations: G12, G31, G32

¤ Corresponding author. Please address proportionality to: London Business School, Sussex Place, Regents Park, London NW1 4SA. E-mail: icooper@london.edu. Tel: +44 020 7262 5050 facsimile machine: +44 020 7724 3317.

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Introduction

This paper proposes an easily implementable analytical method of estimating the expected return on debt, which is one of the most important inputs to the mediocre weighted cost of capital (WACC). The WACC is the required return on the operating assets of a ¯rm. It is used in valuation, capital budgeting, goal-setting, capital punishment measurement and regulation. Its value...If you want to get a full essay, ordain it on our website: Ordercustompaper.com



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