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CFA Level II Exam · Cost of Capital: Advanced Topics

How to Estimate the Cost of Debt for CFA Level II

Updated 7 October 2026 · Fact-checked

The cost of debt is the return lenders require on a company's borrowing today. Estimate the pre-tax cost as the yield to maturity on its traded bonds. If none trade, use matrix pricing or a rating-based spread. Then multiply by (1 − tax rate) to get the after-tax cost used in WACC.

Understand Cost of Debt Estimation

A company's cost of debt is the rate it would pay to borrow now, at current market conditions. It is not the coupon on bonds issued years ago. The coupon reflects past conditions. The market yield reflects today's.

The standard estimate is the yield to maturity (YTM) on the firm's existing long-term bonds. YTM is the discount rate that equates the bond's price to the present value of its promised coupons and principal. It is the return you earn if the bond pays as promised and you hold to maturity. Because default is possible, YTM slightly overstates expected return. For investment-grade debt the gap is small, so YTM is accepted as the cost of debt.

If the firm's bonds do not trade often, or the firm has no traded debt, you use the debt rating approach. You take the firm's credit rating (actual or synthetic), find the yield on comparable bonds with the same rating and similar maturity, and use that. Matrix pricing is the related tool for pricing a thinly traded or newly issued bond. You take the yields of similar liquid bonds, adjust for differences in maturity and credit quality, and estimate the yield for the target bond.

Special cases appear in vignettes. For floating rate debt, the cost is a reference rate plus a spread, so you estimate the current reference rate (or its forward path) and add the spread. For leases, the cost is the rate on a similar-term, similar-risk secured borrowing, or the lease's implicit rate. Interest is tax deductible in most settings, so the after-tax cost is lower than the pre-tax cost. Use the marginal tax rate, because the next unit of debt is taxed at that rate.

Key formulas to remember

After-tax cost of debt
rd(1 − t)
rd is the pre-tax cost (YTM). t is the marginal tax rate. Use this in WACC.
Bond price from YTM
P = Σ [PMT ÷ (1 + y/m)^k] + FV ÷ (1 + y/m)^N
Solve for y to find YTM. m is periods per year. N is the total number of periods.
Annualising a periodic YTM
Annual YTM (bond-equivalent) = periodic yield × m
For semiannual bonds, double the six-month yield. This is the stated annual rate, not the effective rate.
Approximate YTM
YTM ≈ [C + (FV − P) ÷ N] ÷ [(FV + P) ÷ 2]
A quick check only. Use the calculator for the exam answer.
Debt rating approach yield
Yield ≈ benchmark yield + credit spread for the rating
Match rating and maturity. Spread comes from the vignette's exhibit.
Floating rate cost
rd = reference rate + quoted spread
Use the current or expected reference rate, not the rate at issue.

How to solve Cost of Debt Estimation questions

Use this sequence for any cost of debt question in a vignette.

  1. 1Identify what the question asks: pre-tax or after-tax cost, and for which debt (existing bonds, new issue, lease, floating rate).
  2. 2Check whether the firm has actively traded long-term bonds. If yes, use their YTM, not the coupon.
  3. 3If you must compute YTM, set N, PV (negative price), PMT and FV on your calculator. Use the payment frequency from the vignette, then solve for I/Y and multiply by m for the annual figure.
  4. 4If no traded bonds exist, use the rating approach or matrix pricing. Find bonds with the same rating and similar maturity in the exhibit, and adjust for any maturity or rating gap.
  5. 5For floating rate debt, add the current reference rate to the spread. For leases, use the incremental borrowing rate or implicit rate given.
  6. 6Pick the marginal tax rate, not the average or effective rate, unless the vignette says otherwise.
  7. 7Compute rd × (1 − t) and check the result is lower than the pre-tax rate.
  8. 8Match your answer to the closest option and check units (annual, percent).

Quickest way: Yield first, tax last

When to use it: Use when the vignette gives a bond price or a rating table and asks for the after-tax cost of debt.

  1. Underline the word 'current' price or 'market' yield. Ignore the coupon unless you need it as PMT.
  2. Enter N, PV, PMT, FV in the calculator and compute I/Y in one pass.
  3. Multiply by m only if the question wants an annual rate.
  4. For matrix pricing, interpolate between two bracketing maturities in the exhibit and add any rating spread difference.
  5. Multiply by (1 − marginal tax rate) as the last step.

Common mistakes in Cost of Debt Estimation

  • Using the coupon rate as the cost of debt.

    The coupon is easy to see in the vignette and looks like an interest rate.

    Fix: The cost of debt is the current market yield. Use the coupon only as the PMT input to find YTM.

  • Forgetting to double or halve the periodic yield for semiannual bonds.

    The calculator returns the per-period rate, and candidates copy it directly.

    Fix: Set N to the number of periods and multiply the periodic I/Y by the number of periods per year to get the annual YTM.

  • Applying the tax shield twice or not at all.

    Candidates mix up pre-tax inputs and WACC requirements.

    Fix: WACC uses after-tax cost of debt. Apply (1 − t) once, to the pre-tax rate.

  • Using the effective tax rate instead of the marginal rate.

    The financial statements show an effective rate, so it feels like the right figure.

    Fix: Use the marginal rate on the next unit of interest, unless the question explicitly gives another rate to use.

  • Using the rate at issue for floating rate debt.

    The vignette states the original reference rate and spread.

    Fix: Use today's reference rate plus the spread, since the cost reflects current conditions.

  • Matching a rated peer with the wrong maturity in matrix pricing.

    Candidates pick the nearest rating and ignore the term.

    Fix: Match rating first, then adjust for maturity by interpolating along the yield curve of that rating.

Worked examples

Example 1

Vignette: Marlowe Industries has a 10-year bond with a 6% annual coupon, face value 1,000, currently priced at 1,085.30 (annual payments). Marlowe's marginal tax rate is 25%. Q1: What is the pre-tax cost of debt? Q2: What is the after-tax cost of debt?

Show the solution
  1. Set N = 10, PV = −1,085.30, PMT = 60, FV = 1,000.
  2. Compute I/Y. Check: at 5%, the price is 60 × 7.7217 + 1,000 × 0.6139 = 463.30 + 613.91 = 1,077.21. Price is higher than that, so yield is below 5%.
  3. At 4.8%, the annuity factor is (1 − 1.048^−10) ÷ 0.048. 1.048^10 ≈ 1.6007, so 1.048^−10 ≈ 0.6247 and the factor ≈ 7.8186. Price ≈ 60 × 7.8186 + 624.7 = 469.1 + 624.7 = 1,093.8, which is above 1,085.30.
  4. Interpolate between 4.8% (1,093.8) and 5.0% (1,077.2): the fall of 8.5 from 4.8% is 8.5 ÷ 16.6 ≈ 0.51 of the 0.2% gap, giving about 4.90%.
  5. Pre-tax cost ≈ 4.90%.
  6. After-tax cost = 4.90% × (1 − 0.25) = 3.68%.

Answer: Pre-tax cost of debt ≈ 4.90%; after-tax cost ≈ 3.68%. The coupon of 6% is not the cost because the bond trades at a premium.

Example 2

Vignette: Kestrel Labs has no traded debt. Its synthetic rating is BBB. An exhibit shows BBB bonds yielding 5.2% at 5 years and 5.8% at 10 years. Kestrel plans to borrow for 8 years. Its marginal tax rate is 30%. Q1: Estimate Kestrel's pre-tax cost of debt using matrix pricing. Q2: What is the after-tax cost?

Show the solution
  1. Match the rating: use the BBB row.
  2. Interpolate for 8 years between 5 and 10 years. Position = (8 − 5) ÷ (10 − 5) = 0.6.
  3. Yield = 5.2% + 0.6 × (5.8% − 5.2%) = 5.2% + 0.36% = 5.56%.
  4. After-tax cost = 5.56% × (1 − 0.30) = 5.56% × 0.70 = 3.89%.

Answer: Pre-tax cost ≈ 5.56%; after-tax cost ≈ 3.89%.

Exam tips

  • The vignette often gives both a coupon and a market price. Always compute YTM from the price. The coupon is a distractor for the cost of debt.
  • Check whether the question wants pre-tax or after-tax. Many wrong options are the other one.
  • Check payment frequency before you key N and multiply the periodic rate back to an annual figure.
  • For matrix pricing, read the exhibit axes carefully: rating on one axis, maturity on the other. Interpolate only between bracketing maturities.
  • For leases and floating rate debt, think 'current market rate for similar risk and term' and discard historical rates.

Cost of Debt Estimation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost of Debt Estimation: frequently asked questions

Why use YTM and not the coupon rate as the cost of debt?

The cost of debt is what the firm would pay to borrow today. YTM reflects current market conditions. The coupon was fixed at issue and may be far from today's required return.

When do I use matrix pricing for cost of debt?

Use it when the firm's debt is not actively traded or when a new bond has no market price. You estimate its yield from similar liquid bonds, adjusting for maturity and credit quality differences.

What is the debt rating approach?

You take the firm's actual or synthetic credit rating and use the market yield on comparable bonds with the same rating and similar maturity. It is used when the firm has no traded debt of its own.

Which tax rate should I use for after-tax cost of debt?

Use the marginal tax rate, because interest on new debt is deducted at that rate. Use the effective rate only if the question tells you to.