hard · Principles of Finance cost-of-capital-structure

For estimating the firm's WACC as a discount rate for EXPECTED cash flows, what is the key conceptual error?

1. The promised YTM overstates the EXPECTED return to debtholders because it ignores default losses; the cost of debt for discounting expected cash flows should be the expected (default-adjusted) return, which is below 7% pre-tax, so 5.25% is biased high.
2. The YTM is the correct cost of debt to use because it is the contractual rate the firm promises to pay its lenders each year, and the embedded default probability is the bondholders' own risk to bear, not a true economic cost borne by the firm.
3. The analyst should instead add the full observed credit spread on top of the promised 7% YTM figure in order to properly capture default risk, since the cost of debt must separately compensate lenders for the expected loss given eventual default on these bonds.
4. The tax adjustment itself is the real error here: risky debt's interest shield should not be tax-affected at all under this standard valuation framework, so the correct cost of debt for WACC purposes is simply the full 7% promised yield, left entirely untaxed.

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