CMA Intermediate · Financial Management and Business Data Analytics · Cost of Capital
A firm's 11% bonds currently trade in the market and the yield to maturity (YTM) on comparable bonds is 9%. For computing the firm's cost of debt for capital budgeting, which figure is the most appropriate pre-tax cost of debt?
The appropriate pre-tax cost of debt is 9%, the current market yield to maturity. Cost of capital should reflect the present marginal cost of raising new debt, not the historical coupon rate, which was fixed at issue and may differ from today's market conditions.
- A11%, the historical coupon rate
- B9%, the current market yieldCorrect
- C20%, coupon plus yield
- D2%, the difference between coupon and yield
Explanation
Cost of capital is a forward-looking, marginal measure, so the current market yield (9%) reflects what the firm would pay to raise debt today. The coupon is a historical contract rate and does not represent the present cost of new borrowing.
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