Question

When calculating a divisional cost of capital, what is the usual way of estimating the cost of debt for the division?

Question 7 options:

	A) Getting a division-specific credit rating from one of the credit rating agencies, and using it in the default-spread model to estimate cost of debt.
	B) Averaging the yield-to-maturity from pure-play comps.
	C) Using the parent firm's cost of debt, as risk to creditors is more firm-specific than industry-specific.
	D) Unlevering the cost of debt from pure-play comps, and relevering it to the target division.

Answer 1

The best way to calculate a divisional cost of debt is to use the parents firms cost of debt as risk to creditors is more firm specific as interest payments are made from the firms income statement. Only the risk to equity holders differ as depending on the pure play beta , the levered cost of equity is calculated with appropriate debt to equity ratio.

Answer is C) Using the parent firm's cost of debt, as risk to creditors is more firm-specific than industry-specific.