Abstract
We propose a method to estimate the cost of debt in a continuous-time framework with an infinite time horizon. The approach builds on the class of well-known earnings before interest and taxes (EBIT)-based models. It extends other approaches based on option-pricing theory with a finite one-period horizon. 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, since most of its input parameters are readily observable, while the output, the model-implied cost of debt, proves to be very insensitive with respect to the remaining non-observable parameters, the EBIT growth rate, and the bankruptcy costs of the firm. We demonstrate the applicability of the cost of debt to calculate an approximate weighted average cost of capital for the purpose of firm and project valuation, and its usage and limitations.
Highlights
Cost of capital is one of the central issues in corporate finance
We show the applicability of the textbook formula of the weighted average cost of capital (WACC) for instantaneous returns, but demonstrate its inconsistencies for long-term returns
The cost of debt is an essential component of the cost of capital, which is a central figure in a number of applications, such as capital budgeting, performance measurement, and firm valuation
Summary
Cost of capital is one of the central issues in corporate finance. For a company’s management, the cost of capital is an important benchmark for capital budgeting and performance measurement. When risk aversion is greater than zero, the model can be used to split the yield spread into the default premium and the risk premium: using riskneutral valuation, the debt value is the sum of expected payments to bondholders under the risk-neutral measure, discounted by the risk-free rate. Instead of directly calculating the cost of capital for the total firm, it is very common in practice to estimate the cost of equity and the cost of debt separately Such an approach allows us to place the actual cost of debt between the two polar values: the risk-free rate and the yield to maturity of corporate debt.
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