Estimating the Cost of Risky Debt

Posted: 10 Oct 2007

See all articles by Sergei A. Davydenko

Sergei A. Davydenko

University of Toronto - Finance Area

Ian A. Cooper

London Business School

Abstract

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

Davydenko, Sergei A. and Cooper, Ian Anthony, Estimating the Cost of Risky Debt. Journal of Applied Corporate Finance, Vol. 19, No. 3, 2007, Available at SSRN: https://ssrn.com/abstract=1020612

Sergei A. Davydenko

University of Toronto - Finance Area ( email )

Toronto, Ontario M5S 3E6
Canada

Ian Anthony Cooper (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 171 262 5050 (Phone)

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