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When calculating the weighted average cost of capital (WACC), it may be tempting to use the debt yield (yield to maturity, YTM) as the cost of debt. However, Berk & DeMarzo note in Chapter 12 of "Corporate Finance - 5th Global Edition" (see box "Common Mistake" on p. 454) that doing that would be a mistake. This is because the interest payments and the repayment of the principal are only promised, not actual. In case of a bankruptcy1, these payments may be reduced. Therefore, the actual cost of capital is lower than the interest rate on the loan.

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This issue is minor to the point that it can be neglected for relatively safe debt (for sure if rated AAA or AA, mostly so if rated A and BBB, according to Table 12.2 on p. 454), but can become pretty significant for high-risk debt (BB and lower, ibid.).

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In practice, how can we adjust YTM for the possibility of bankruptcy so that we obtain a fair estimate of the cost of debt? Does that have to be done on a case to case basis, drawing future scenarios of how much would be repaid under different circumstances and assigning probabilities to them? Or is there a simpler way?

1It does not always have to be bankruptcy, there can be more complicated cases, too.

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    $\begingroup$ You just add a credit spread. There are usually lots of estimated curves on systems like Bloomberg for all sorts of ratings and types (government l, financials, non financials,...) $\endgroup$
    – Alex
    Oct 15, 2022 at 15:24
  • $\begingroup$ @Alex, thank you for the idea. Would you please explain it in more detail, ideally by posting an answer? $\endgroup$ Oct 15, 2022 at 15:26
  • $\begingroup$ That was a hasty comment. Essentially, YTM already has credit risk incorporated but to check what a fair value will be, you can split the yield into risk free and spread. I'll need to think about the statement you reference because additional haircuts make little sense for your own firm in a base scenario because you don't use bankruptcy in your (expected) going concern scenario. If you do, you are mainly looking at junk bonds and companies that would default with near certainty. Interesting. Not sure within the context of wacc because my firm doesn't compute that. $\endgroup$
    – Alex
    Oct 15, 2022 at 16:33
  • $\begingroup$ If no one answers, I may spend some time reading on this out of interest. The box mentions that the book shows methods. Did they not satisfy you? $\endgroup$
    – Alex
    Oct 15, 2022 at 16:34

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