What is the primary method for estimating the cost of debt?

The primary method for estimating the cost of debt involves observing the yield on debt with equivalent risk. This method is grounded in the idea that the cost of debt reflects the returns demanded by investors for taking on the risk of lending to a particular borrower or bond issuer. By examining the yields on bonds or debt instruments that have a similar credit rating and risk profile to the debt being evaluated, analysts can determine a relevant benchmark for the cost of debt.

This approach is preferred because it provides a market-based perspective on what investors are currently willing to accept as compensation for risk, taking into account prevailing economic conditions and interest rates. In contrast, other methods, such as using the average equity return of competitors or calculating historical average interest rates, do not directly correlate with the specific risks associated with the current debt being analyzed. Borrowing costs from lending banks may offer some insights but can be less reliable as market conditions change over time. Thus, focusing on the yield of comparable debt provides a more accurate and relevant estimate for assessing the cost of debt.