Can CAPM be used to estimate the cost of debt?

• A. No, it only estimates the cost of equity
• B. Yes, with slight alterations to inputs
• C. Yes, but only for large capitalized companies
• D. No, it cannot be applied to debt at all

Answer: (B)

The Capital Asset Pricing Model (CAPM) can indeed be adapted to estimate the cost of debt with some slight modifications to the inputs. The CAPM traditionally focuses on equity by relating the expected return of an asset to its systematic risk, quantified by beta. However, to use CAPM for estimating the cost of debt, adjustments are made to account for the nature of debt financing.

For debt, the focus shifts from equity risk premium to the yield spread over a risk-free rate, typically represented by government bonds. The idea is to adjust the input parameters such as the risk-free rate and potentially the debt’s specific risk characteristics to align with the risk profile of the company’s debt rather than its equity. This modified approach allows practitioners to derive a reasonable estimate of the cost of debt based on market data and historical performance metrics.

Utilizing CAPM in this way enhances the utility of the model beyond its original intent, demonstrating its flexibility in finance for estimating various forms of capital costs.