Which of the following statements regarding a firm’s pretax cost of debt is accurate?

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BlackTom AI · Accepted Answer

The question asks which statement about a firm’s pretax cost of debt is accurate, so I will evaluate each option in turn before identifying the correct one.
Option 1: 'It is equivalent to the average current yield on all of a company's outstanding bonds.' This is not correct because the pretax cost of debt is typically proxied by the yield to maturity (YTM) on existing debt, not simply the average current yield. Current yields reflect annual coupon relative to price on individual bonds and can differ from the true cost of debt embedded in the YTM, which incorporates the full period-to-maturity cash flows and the market price. Therefore, using an average current yield would misstate the cost because it ignores the time value of money and the specifics of each bond's cash flows.
Option 2: 'It must be estimated as it cannot be directly observed in the market.' This is incorrect because the pretax cost of debt can be observed and estimated from market prices of existing debt issues. If bonds are publicly traded, their yields to maturity provide a market-based measure of the firm’s cost of debt. Even for non-traded debt, estimates can be made using comparable debt or by discounting expected cash flows, but it is not true that it cannot be observed or estimated at all.
Option 3: 'It is equal to the coupon rate on the latest bonds issued by the company.' This is inaccurate because the coupon rate on new issues reflects contractual payments at issuance and does not capture current market conditions or the price today. The pretax cost of debt, however, reflects the yield that investors require given current coupons, prices, and maturities, i.e., the yield to maturity, not the coupon rate of the latest issue.
Option 4: 'It is equal to the original yield to maturity on the latest bonds issued by a company.' This is misleading because the original YTM at issuance is a function of the issue price and terms at that time and may differ from the yield to maturity observed today for existing bonds. The firm’s current cost of debt should reflect current market yields on outstanding debt, not the historical YTM when the bonds were first issued.
Option 5: 'It is based on the current yield to maturity of the company's outstanding bonds.' This statement aligns with standard practice: the pretax cost of debt is proxied by the yield to maturity on existing debt, reflecting the market’s required return for the firm’s current debt structure. This captures both coupon cash flows and the price today, giving a proper measure of cost before taxes.
In summary, the only option that correctly describes how to determine the pretax cost of debt in practice is the one stating it is based on the current yield to maturity of the company's outstanding bonds, while the other choices either misstate the relationship between coupons, prices, and yields or rely on outdated or inappropriate benchmarks.

BUSFIN 3220 AU2025 (2910) Exam 3 - Requires Respondus LockDown Browser

Which of the following statements regarding a firm’s pretax cost of debt is accurate?

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