The Cost of Debt

The cost of debt is the return that the firm's creditors demand on new borrowing. In principle, we could determine the beta for the firm's debt and then use the SML to estimate the required return on debt just as we estimated the required return on equity. This isn't really necessary, however.

Unlike a firm's cost of equity, its cost of debt can normally be observed either directly or indirectly, because the cost of debt is simply the interest rate the firm must pay on new borrowing, and we can observe interest rates in the financial markets. For example, if the firm already has bonds outstanding, then the yield to maturity on those bonds is the market-required rate on the firm's debt.

Alternatively, if we know that the firm's bonds are rated, say, AA, then we can simply find out what the interest rate on newly issued AA-rated bonds is. Either way, there is no need to estimate a beta for the debt because we can directly observe the rate we want to know.

There is one thing to be careful about, though. The coupon rate on the firm's outstanding debt is irrelevant here. That rate just tells us roughly what the firm's cost of debt was back when the bonds were issued, not what the cost of debt is today.5 This is why we have to look at the yield on the debt in today's marketplace. For the sake of consistency with our other notation, we will use the symbol RD for the cost of debt.

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