[Evan]

[ QUOTE ]
Have you had Damodaran at NYU? I was just flipping through one of his books today. How is he as a teacher?

[/ QUOTE ]
He only teaches grad classes, so I haven't had him yet. I've sat in on some of his classes and he's given a few presentations to a club I'm in. He is exceptionally good at explaining difficult ideas in ways that make them easy to understand.

[ QUOTE ]
When that firm is faced with a marginal project, how much will they be charged to finance that project via equity funding?

[/ QUOTE ]
Okay, I can agree with that. But does that means that's the rate you should be using to value the company? If it is then every company you value will be excactly fairly valued because you're taking the market price as a given. I'm not saying that's not the current market cost of equity, so I guess we agree. However, that is not necessarily the rate you should discount future cash flows at. I think you have to agree with that, right?

[ QUOTE ]
I'm really surprised to see you disagree with the cost of debt.

[/ QUOTE ]
Your example is correct when examined in a vacuum. The problem is that bonds are issues/traded much less frequently than stocks. If there was a debt issue or trade very recently then it is fine to use market quotes. In many instances though, there may have been months or years since any market data was quoted.

A good example of when market interest rates have been useless is Salton. About a year ago they went through massive refinancing after taking huge (see HUGE) writedowns and restructuring charges that equated to losses of about $8.50/share on a stock trading for ~$6 at the time. Obviously this was more an example of "big bath accounting" than anything else, but the point is they were doing very, very poorly. During this time their market quoted cost of debt remained the same, even though they were obviously sucking wind pretty hard (they had a TON of debt at this time, so it's not like these rates were immaterial). Next, they defaulted. For those that aren't familiar with finance, this is sort of like bancruptcy, excpet that in this case it was a technical default. When you borrow huge amounts of money, as Salton had, you get convenants put on your debt like, "you have to make $x/year in operating income". Needless to say, Salton fell WELL below the required interest coverage ratio due to the writedowns and restructuring. Here's the twist, they lose a bunch of money, default on their debt, but their cost of debt doesn't move up at all. Why? Because the debt holders really had no leverage to do anything to the company. Management was already getting fired, there were new and promising products comign to market, and it looked like things could turn around. Salton didn't issue any new debt and no one wanted to buy their old debt (and the current debt holders didn't really want to sell since they'd get next to nothing for it anyway).

I know that got a little longwinded, but the point is that market rates, for debt or equity, really don't imply as much as you might think about future rates that should be applied to future cash flows.