The Cost of Debt

Abstract

This paper proposes a practical way of estimating the cost of risky debt for use in the cost of capital. The cost of debt is different from both the promised yield and the risk-free rate, which are sometimes used for this purpose, because of the expected probability of default. 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 are easily observable. The parameters of the Merton model implied by these inputs are used to compute the expected return on debt. It is argued that, although Merton's framework is simple and stylised, it can 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 values that are typical for high grade 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 likely to cause significant 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 firm's debt.

JEL Classification: G31, G32, G12