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Interest Rates and the Cost of Debt

The cost of debt is the rate of return that investors in a firm's debt expect when purchasing the firm's debt securities. In principle, the beta for the firm's debt could be determined, and we could use the security market line to determine the required return on the firm's debt. In practice, we assume that the beta of a firm's debt is close enough to zero to assume it is, in fact, zero.

The cost of debt is usually easy to determine by looking at the yield to maturity of a firm's outstanding bonds. Similary, if the firm's credit rating was an A, we could look at market rates for bonds with the same credit rating. The interest rate the firm pays is usually broken into two components: the risk free rate, and a default risk premium. This is because corporate bonds, unlike US Treasury Bills (for example), have a risk of default.

Where
r
= the rate of return on debt
rrisk-free = the risk-free rate of return

The coupon rate on the firm's outstanding debt usually reflects the firm's cost of debt when these securities were issued. The coupon rate should not be used to determine the firm's current cost of debt. To find today's cost of debt, we can look at the price of bonds currently in the market, and the corresponding expected yield to maturities.

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