CFA Practice Question

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CFA Practice Question

The before-tax cost of debt to a corporation at any point in time is ______.

A. the current market borrowing rate
B. greater than the risk-free rate if the bond beta is negative
C. equal to the coupon payment
D. the stated interest on the debt instrument
Correct Answer: A

User Contributed Comments 7

User Comment
quynhnk79 why not D? someone can explain?
achu 'at any point in time' is the key phrase. At inception maybe D is true but as market changes, D no longer hold.
8thlegend Different debt instruments, different states interest rates.

Too much for a firm to deal with
czar The stated interest rate maybe on a premium bond (higher interest rate than par) or a discount bond (lower interest than par). such interest rates don't indicate the market rate at tht point of time.
Secondly, YTM approach requires the mkt rate in the calc. of debt component for WACC
dmfz I disagree, the coupon payment is the coupon payment, the bond maybe trading at 40 and if you and if it was $1000 bond with a 10% coupon, you will pay $5 regadless.
assiduous This question isn't worded the best. I like the intent behind the question but it confuses those who aren't 100% clear on the concept. The way the question is worded both A and D are correct. Using czar's explanation A is correct. Using dmfz explanation D is correct.
Perhaps "The before-tax cost of 'new' debt" is more clear cut.

Take a company whose debt ratings dip below investment grade. The before-tax cost would still be the stated interest on the debt for any debt capital received when the company had investment grade ratings. However, should the company seek out any additional debt capital, the before-tax cost of the new debt will be subject to the current market borrowing rate.

Also, considering debt capital is outstanding for years on in, the phrase "at any point in time" is really misleading.
Teeto WACC is foward looking. So opportunity cost is always a market one, since opportunities are valued by the market.
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