I’m reading SN for Corporate Finance, June 2014 Reading #37- Cost of Capital
I do not quite understand the Professor’s Note :
It is important that you realize that the cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm’s existing debt. CFA Institute may provide you with both rates, and you need to select the current market rate.
Question: Is the note trying to tell us that cost of debt will fluctuate from time to time, and it will be based on the last YTM during the period of consideration i.e. if YTM stand at 5% during valuation date, the YTM used to value debt will be 5%.
I’m just about to hit that reading, but here’s what I think:
You would not use the coupon rate because it does not reflect your firm’s cost of debt. Coupon rates can range from 0 to who know what, it’s up to the issuing body to decide. The low/high coupon will be offset by the sale price below/above par. YTM on the other hand truly reflects how much it would cost you to raise more debt (new debt), and that is why we would use it.
If anyone can confirm or deny my thoughts, please do. That’s just how I understand this concept.
Yes. Coupon rate on the firm’s existing debt is merely the coupon rate of past debts that the firm had taken, which does not reflect the current market interest rate (YTM).
Should the firm takes a new debt now, the cost of taking up this new debt should be the current market interest rate (YTM).
In effect, the market is telling you at any moment what it believes the coupon rate should be: the YTM. If they perceive you as more risky, the YTM goes up; if they perceive you as less risky, the YTM goes down. If they become more risk averse (in general), the YTM goes up; if they become less risk averse (in general), the YTM goes down.