<p>When calculating the weighted average cost of capital (WACC), it may be tempting to use the debt yield (yield to maturity, YTM) as the cost of debt. However, Berk &amp; DeMarzo note in Chapter 12 of <a href="https://www.pearson.com/se/Nordics-Higher-Education/subject-catalogue/finance/corporate-finance-5e-berk-and-demarzo.html" rel="nofollow noreferrer">&quot;Corporate Finance - 5th Global Edition&quot;</a> (see box &quot;Common Mistake&quot; on p. 454) that doing that would be a mistake. This is because the interest payments and the repayment of the principal are only <em>promised</em>, not actual. In case of a bankruptcy<sup>1</sup>, these payments may be reduced. Therefore, the actual cost of capital is lower than the interest rate on the loan.</p>
<p><a href="https://i.sstatic.net/Rpu95.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/Rpu95.png" alt="enter image description here" /></a></p>
<p>This issue is minor to the point that it can be neglected for relatively safe debt (for sure if rated AAA or AA, mostly so if rated A and BBB, according to Table 12.2 on p. 454), but can become pretty significant for high-risk debt (BB and lower, ibid.).</p>
<p><a href="https://i.sstatic.net/PFy8k.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/PFy8k.png" alt="enter image description here" /></a></p>
<p>In practice, how can we adjust YTM for the possibility of bankruptcy so that we obtain a fair estimate of the cost of debt? Does that have to be done on a case to case basis, drawing future scenarios of how much would be repaid under different circumstances and assigning probabilities to them? Or is there a simpler way?</p>
<p><sup>1</sup>It does not always have to be bankruptcy, there can be more complicated cases, too.</p>

CC BY-SA 4.0
2022-10-15T15:15:16.363Z
Related: ["Does a private company that is 100% financed by a bank loan have a WACC equal to the interest rate?"](https://economics.stackexchange.com/questions/32798).
Richard Hardy
CC BY-SA 4.0
2022-10-15T15:24:39.520Z
You just add a credit spread. There are usually lots of estimated curves on systems like Bloomberg for all sorts of ratings and types (government l, financials, non financials,...)
Alex
CC BY-SA 4.0
2022-10-15T15:26:56.197Z
@Alex, thank you for the idea. Would you please explain it in more detail, ideally by posting an answer?
Richard Hardy
CC BY-SA 4.0
2022-10-15T16:33:17.837Z
That was a hasty comment. Essentially, YTM already has credit risk incorporated but to check what a fair value will be, you can split the yield into risk free and spread. I'll need to think about the statement you reference because additional haircuts make little sense for your own firm in a base scenario because you don't use bankruptcy in your (expected) going concern scenario. If you do, you are mainly looking at junk bonds and companies that would default with near certainty. Interesting. Not sure within the context of wacc because my firm doesn't compute that.
Alex
CC BY-SA 4.0
2022-10-15T16:34:54.603Z
If no one answers, I may spend some time reading on this out of interest. The box mentions that the book shows methods. Did they not satisfy you?
Alex
CC BY-SA 4.0
2022-10-15T16:43:53.500Z
@Alex, no, the methods did not satisfy me. The section that contains the box is quite short, and it discusses only two methods. The second one is CAPM, but it is not very convenient unless the debt is tradeable. The first one considers scenarios just like I described in my question; an example is provided, but it is very simplistic and case specific.
Richard Hardy
<debt><corporate-finance><cost><capital>
Cost of debt: How to adjust YTM for the possibility of bankruptcy?
Richard Hardy
# Cost of debt: How to adjust YTM for the possibility of bankruptcy?

(Asked by: username_0 on 2022-10-15)

When calculating the weighted average cost of capital (WACC), it may be tempting to use the debt yield (yield to maturity, YTM) as the cost of debt. However, Berk & DeMarzo note in Chapter 12 of ["Corporate Finance - 5th Global Edition"](https://www.pearson.com/se/Nordics-Higher-Education/subject-catalogue/finance/corporate-finance-5e-berk-and-demarzo.html) (see box "Common Mistake" on p. 454) that doing that would be a mistake. This is because the interest payments and the repayment of the principal are only *promised*, not actual. In case of a bankruptcy1, these payments may be reduced. Therefore, the actual cost of capital is lower than the interest rate on the loan.

[![enter image description here](https://i.sstatic.net/Rpu95.png)](https://i.sstatic.net/Rpu95.png)

This issue is minor to the point that it can be neglected for relatively safe debt (for sure if rated AAA or AA, mostly so if rated A and BBB, according to Table 12.2 on p. 454), but can become pretty significant for high-risk debt (BB and lower, ibid.).

[![enter image description here](https://i.sstatic.net/PFy8k.png)](https://i.sstatic.net/PFy8k.png)

In practice, how can we adjust YTM for the possibility of bankruptcy so that we obtain a fair estimate of the cost of debt? Does that have to be done on a case to case basis, drawing future scenarios of how much would be repaid under different circumstances and assigning probabilities to them? Or is there a simpler way?

1It does not always have to be bankruptcy, there can be more complicated cases, too.

**Tags:** debt, corporate-finance, cost, capital
> **Comments:**
> **username_0**: Related: ["Does a private company that is 100% financed by a bank loan have a WACC equal to the interest rate?"](https://economics.stackexchange.com/questions/32798).  
> **username_1**: You just add a credit spread. There are usually lots of estimated curves on systems like Bloomberg for all sorts of ratings and types (government l, financials, non financials,...)  
> **username_0**: @Alex, thank you for the idea. Would you please explain it in more detail, ideally by posting an answer?  
> **username_1**: That was a hasty comment. Essentially, YTM already has credit risk incorporated but to check what a fair value will be, you can split the yield into risk free and spread. I'll need to think about the statement you reference because additional haircuts make little sense for your own firm in a base scenario because you don't use bankruptcy in your (expected) going concern scenario. If you do, you are mainly looking at junk bonds and companies that would default with near certainty. Interesting. Not sure within the context of wacc because my firm doesn't compute that.  
> **username_1**: If no one answers, I may spend some time reading on this out of interest. The box mentions that the book shows methods. Did they not satisfy you?  
> **username_0**: @Alex, no, the methods did not satisfy me. The section that contains the box is quite short, and it discusses only two methods. The second one is CAPM, but it is not very convenient unless the debt is tradeable. The first one considers scenarios just like I described in my question; an example is provided, but it is very simplistic and case specific.  

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## 0 answers

