Finding Cost of Capital when the Market Value of Debt is not Known

Abstract

Analysts usually estimate the cost of capital by using the market capitalization as a proxy for equity, and the book value of debt as a proxy for debt. This method is often justified by arguing that for healthy companies there is not much of a difference between the book and the market values of debt. Pre-tax cost of debt is however a function of both the overall interest rate in the economy and the credit worthiness of the company. Even if the company remains healthy, a change in the overall interest rate can change the pre-tax cost of debt of a company. One must therefore estimate the cost of capital by using the market value of debt even for the healthy companies. In this paper we suggest a simple iterative approach that can be used to estimate both the true value of cost of capital and the market value of debt. This method does not require any free cash flow forecasting by the analyst.