Question

Describe why it is not usually appropriate to use the coupon rate on a firm’s bonds...

Describe why it is not usually appropriate to use the coupon rate on a firm’s bonds to estimate the pretax cost of debt for the firm.

Homework Answers

Answer #1
  • The pre-tax cost of debt for the firm is the current annual economic cost of borrowing for the firm (before any tax effects).
  • That cost is better measured by the current yield to maturity on the firm’s debt than by the coupon rate that is currently paid on that debt. Since most firms try to issue new bonds very close to par, the coupon rate on a bond is an indication of the yield to maturity on the bond issue at the time of issue.
  • Unless the market-determined borrowing rate for the firm is the same as when the bond was issued, then the current yield to maturity of a bond will not be equal to the current coupon rate on the bond.
  • So, because of the above reasons,it is not appropriate to use the coupon rate on a firm's bonds.
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