The Cost of Debt Capital Revisited
34 Pages Posted: 26 Apr 2012
Date Written: March 15, 2012
We propose a method to consistently estimate the cost of debt in a continuous-time framework with an infinite time horizon. The approach builds on the EBIT-based model of Goldstein et al. (2001). The model is capable of splitting the observed yield spread of a corporate bond into the risk premium, which adds to the expected return of bondholders, and the default premium, which accounts for expected losses. The model can easily be calibrated for non-public firms. The model-implied cost of debt proves to be very insensitive with respect to non-observable parameters. Analyzing the weighted average cost of capital (WACC) in the model, we demonstrate potential errors from using the textbook formula for the WACC.
Keywords: cost of capital, cost of debt, EBIT-based model, WACC, yield spread
JEL Classification: G30
Suggested Citation: Suggested Citation