additiontothecostofequity,andtakingaweightedaverage
ofthecosts.Inthissubsection,weconsiderfirstthecostsof
theseothercomponentsand thentheweightingmechanism
for estimating cost of capital.
Costs of Nonequity Financing
Toestimatethecostofthefundingthatafirmraises,wehave
toestimatethecostsofallofthenonequitycomponents.In
this subsection,we considerthecost ofdebtfirstand then
extend the analysis to consider hybrids such as preferred
stock and convertible bonds.
Cost of Debt
Thecost ofdebt measuresthe currentcost to thefirm of
borrowing funds to finance its assets. In general terms, it
shouldbeafunctionofthedefaultriskthatlendersperceive
inthefirm.As theperceiveddefaultriskincreases,lenders
willchargehigherdefaultspreads(ontopoftherisk-freerate)
tolendtothefirm.Inthissubsection,wewillbeginwitha
generaldiscussionofdefaultriskandthenconsiderhowbest
to measure default risk and the resulting default spreads.
What Is Default Risk?
Incontrasttothegeneralriskandreturnmodelsforequity,
whichevaluatetheeffectsofmarketriskonexpectedreturns,
models of default risk measure the consequences of
firm-specific default risk on promisedreturns. Thedefault
riskofafirmisafunctionoftwovariables.Thefirstisthe
firm’s capacitytogeneratecash flowsfrom operationsand