Chapter 6

Question 1

Discount rate on debt includes two components:

Answer 1

Risk-free rate and premium for default

Question 2

Cost of debt (Rd) = ?

Answer 2

Risk free rate + default premium

Question 3

Cost of equity must be ______ than cost of debt and cost of debt needs to be _______ than risk free rate.

Answer 3

higher, higher
Re>Rd>Rfree

Question 4

What is the first step in estimating cost of debt?

Answer 4

Annualized yield.

Question 5

Use annualized yield if…

Answer 5

bond information is available, bonds have a maturity of about 10 years, and bond quotes are not stale.

Question 6

Annualize yield-to-maturity formula:

Answer 6

cost of debt = (1+yield-to-maturity/m)^m -1
where percentage rate is YTM and m= number of coupons per year.

Question 7

Bonds are traded ________

Answer 7

over the counter (OTC)

Question 8

Second step in estimating cost of debt?

Answer 8

Credit rating

Question 9

Use credit rating if…

Answer 9

if bond data is not available in step one or if bond quotes are stale.

Question 10

How to complete credit rating step:

Answer 10

Find credit rating information and add matching default spread to risk-free rate using the equation,
return on debt = risk-free rate + default spread

Question 11

what is the third step in estimating cost of debt?

Answer 11

Synthetic credit rating

Question 12

when to use step three?

Answer 12

if credit rating is not available in step 2.

Question 13

how to estimate synthetic credit rating?

Answer 13

interest coverage ratio, then look up the credit rating corresponding to the estimated ratio.
interest coverage = operating profit/cash interest paid
= earnings before tax and interest(EBIT)/ cash interest paid

Question 14

what is EBIT?

Answer 14

earnings before tax and interest

Question 15

what is a robustness check?

Answer 15

Book interest equation:
Rd = cash interest paid on debt / average debt

Question 16

when do you perform a robustness check?

Answer 16

after every step perform a robustness check