Theweightedaveragecostofcapitalblendsthecostofequitywiththeafter-tax cost of debt.

To
estimate the cost of debt for investment-grade companies, use the yield to maturity of the
companys long-term, option-free bonds. Multiply
yourestimateofthecostofdebtby1minusthemarginaltaxratetodetermine the cost of debt on
an after-tax basis. Technicallyspeaking,yieldtomaturityisonlyaproxyforexpectedreturn,
because the yield is actually a promised rate of return on a companys debt (it assumes all
coupon payments are made on time and the debt is paid in full).
Anenterprisevaluationbasedontheyieldtomaturityisthereforetheoretically inconsistent, as
expected free cash ows should be discounted by an expected return, not a promised
yield. For companies with investment-grade debt, the
probabilityofdefaultissolowthatthisinconsistencyisimmaterial,especially
whencomparedwiththeestimationerrorsurroundingbetaandthemarketrisk
premium.Thus,forestimatingthecostofdebtforacompanywithinvestmentgradedebt(debtrate
datBBBorbetter),yieldtomaturityisasuitableproxy.For companieswithbelow-investment-

Inpractice,fewnancialanalystsdistinguishbetweenexpectedandpromised returns. But for

debt below investment grade, using the yield to maturity as a proxy for the cost of debt
can cause signicant error.
Tounderstandthedifferencebetweenexpectedreturnsandyieldtomaturity, consider the
following example. You have been asked to value a one-year zero-coupon bond whose
face value is $100. The bond is risky; there is a 25 percent chance the bond will default
and you will recover only half the nal payment. Finally, the cost of debt (not yield to
maturity), estimated using the CAPM, equals 6 percent. Based on this information, you
estimate the bonds

Debt In the United States, the current market value of a companys debt can be
determined using the TRACE pricing database. Exhibit 11.12 shows that Home Depots
2036 bond traded at $80.06, or 80.06 percent of par value at 12:08 on May 28, 2009. To
determine the market value of the bond, multiply 80.06 percent by the bonds book value
of $2,959 million, which equals $2,369 million.49 Since a bonds price depends on its
coupon rate versus its yield, not every Home Depot bond trades at the same price. The
Home Depot bond maturing in 2016 recently closed at 98.53 percent of par over the same
time period. Consequently, value each debt separately.
Ifanobservablemarketvalueisnotreadilyavailable,valuedebtsecurities
atbookvalue,orusediscountedcashow.Inmostcases,bookvaluereasonably approximates
the current market value. This will not be the case, however, if interest rates have
changed since the time of issuance or the company is in
nancialdistress.Inthesetwosituations,thecurrentpricewilldifferfrombook value because
either expected cash ows have changed (increased probability
ofdefaultlowersexpectedcashow)orthediscountratehaschangedfromits original level
(interest rates drive discount rates).50 In these situations, value each bond separately by
discounting promised
cashowsattheappropriateyieldtomaturity.Thesizeandtimingofcoupons will be disclosed
in the notes of a companys annual report. Determine the appropriate yield to maturity by
examining the yields from comparably rated debt with similar maturities.
Debt-equivalentclaims Next,valueoff-balance-sheetdebt,suchasoperating leases and
pension liabilities. As detailed in Chapter 27, operating leases can be valued using the
following formula:
Lease Valuet1 =
Rental Expenset kd + 1 Asset Life
Include operating leases in debt only if you plan to adjust free cash ow for operating
leases as well. Consistency between free cash ow and the cost of capital is paramount.
Any pension adjustments made to free cash ow must be properly represented