Estimating the Cost of Risky Debt
Posted: 10 Oct 2007
When calculating a company's weighted average cost of capital, or WACC, common practise in estimating the expected costs of debt is to use the promised yield on new bonds. Although this practice makes sense in the case of investment-grade issuers of low probabilities of default, the use of yields in the case of risky, particularly high-yield, issuers could materially overstate the cost of debt and, along with it, the WACC. To avoid this distortion, the promised yields on risky debt should be adjusted downward to account for the probability of default and the expected losses associated with it.
To make this adjustment, this article recommends and illustrates the use of Robert Merton's model of risky debt to decompose promised yield spreads into two components: expected return premiums and compensation for expected default losses. The advantage of the proposed approach is that all inputs are easily observed, consistent with current market conditions, and commonly used in calculating the cost of capital.
Keywords: cost of debt, WACC
JEL Classification: G31, G32, G12
Suggested Citation: Suggested Citation