What method determines the before-tax cost of debt?

• A. Yield to Maturity of bond cash flows
• B. Coupon rate
• C. Current yield
• D. Debt-to-equity ratio

Answer: (A)

Determining the before-tax cost of debt relies on what lenders require given current market conditions. Yield to maturity of bond cash flows does this by calculating the internal rate of return an investor would earn if the bond is held to maturity, based on the bond’s current price, its periodic coupon payments, and its par value at the end. This rate captures both the interest received and the eventual repayment of principal, reflecting the market’s required return for borrowing today, before taxes.

Coupon rate is fixed at issue and doesn’t reflect current market prices or the time value of money. Current yield looks only at the annual coupon relative to price and ignores the payoff at maturity and the time to maturity, so it doesn’t fully represent the true cost of debt. Debt-to-equity ratio is a leverage measure, not a cost of debt.