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

Question

BlackTom AI · Accepted Answer

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

Option 1: 'It is based on the original yield to maturity on the latest bonds issued by a company.' This is not correct because the pretax cost of debt reflects the current borrowing costs, not the historical yield at issuance. Using the original YTM would ignore changes in credit risk, interest rates, and market conditions since issuance.

Option 2: 'It must be estimated as it cannot be directly observed in the market.' In principle, the cost of debt for existing debt can be inferred from market data (e.g., the yields on the company’s current bonds or credit spreads). It is observable through market prices and yields, so this statement is misleading.

Option 3: 'It is equivalent to the average current yield on all of a company's outstanding bonds.' The pretax cost of debt is not simply the average current yield. Current yield ignores the present value of principal repayments and does not account for the coupon vs. market price dynamics across once-issued debt. A true measure typically uses YTM on the debt, which reflects both coupon payments and the difference between price and face value.

Option 4: 'It is equal to the coupon rate on the latest bonds issued by the company.' The coupon rate is fixed at issuance and does not reflect the present market cost of debt. The cost of debt for decision-making uses the market-required return (YTM) on outstanding debt, not the coupon rate of new issues alone.

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 estimated from the market-required return on existing debt, which is captured by the current yield to maturity of the company’s outstanding bonds, reflecting coupon payments, price, and time to maturity. This approach accounts for market conditions and credit risk as of the valuation date.

In summary, options 1, 2, 3, and 4 misstate how the pretax cost of debt is determined, either by referencing historical figures, assuming non-observability, relying on an imperfect average, or tying costs to coupon rates rather than market yields. Option 5 correctly identifies the market-based YTM on outstanding debt as the appropriate measure for pretax cost of debt.

BUSFIN 3220 AU2025 (2110) Exam 3 - Requires Respondus LockDown Browser

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

View Explanation

Log in for full answers

Similar Questions

Wright Market Research is able to borrow money at a rate of 6.8 percent per year. This interest rate is called the:

Too Young, Incorporated, has a bond outstanding with a coupon rate of 6.2 percent and semiannual payments. The bond currently sells for $943 and matures in 19 years. The par value is $1,000. What is the company's pretax cost of debt?

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

A firm's aftertax cost of debt will increase if there is a(n):

Wright Market Research is able to borrow money at a rate of 6.8 percent per year. This interest rate is called the:

(Cost of debt) AlterU has the option to issue 15-year bonds at $1,180 with a flotation cost of 7%, tax rate of 34%, and a coupon rate of 6% (paid annually). What is AlterU firm’s cost of debt prior to tax?

More Practical Tools for International Students

Exam Browser Assistant

Stylized Writing Assistant

Plagiarism Checker Assistant

Citation Assistant

In-Class Translation Assistant

Class Notes Assistant

Quiz Search Assistant

Past Exam Questions by School

Smart Practice Assistant

Adaptive Practice

Making Your Study Simpler