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 because it is the rate the firm contractually promises to pay, and default probability is already the bondholders' problem, not the firm's cost.
3. The analyst should ADD the credit spread on top of the 7% YTM to capture default risk, since the cost of debt must compensate for the embedded loss given default.
4. The tax adjustment is the error: risky debt shields should not be tax-affected, so the correct cost of debt is the full 7% promised yield.

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