Session 12: Estimating Hurdle Rates - Debt & its Cost

New Section

In this section, the instructor introduces the concept of debt as a way of raising financing in corporate finance and discusses the criteria for classifying an item as debt.

Defining Debt and Cost of Capital

• The session transitions from estimating the cost of equity to discussing debt as the second component in determining the cost of capital.

• Defining debt involves identifying three key characteristics: contractual commitment to make payments, tax deductibility, and consequences for failing on commitments.

• Criteria for classifying items as debt include contractual payment obligations, tax deductibility, and potential loss of control.

Debt Classification Criteria

This part delves into specific examples to illustrate how certain liabilities may or may not qualify as debt based on defined criteria.

Classifying Liabilities

• Bank loans and corporate bonds are clear examples of debt due to explicit interest expenses.

• Accounts payable or supplier credit may be considered debt if implicit interest expenses are made explicit through cost analysis.

Treatment of Lease Commitments

The discussion shifts towards lease commitments and their classification as debt in financial analysis.

Lease Commitments Analysis

• Lease commitments, common in retail or restaurant businesses, should be treated as debt due to contractual obligations and tax deductibility.

• All lease commitments are viewed as debt regardless of operating or capital lease distinctions.

Cost of Debt Determination

Focuses on understanding how to calculate the cost of debt by considering long-term borrowing rates and default spreads.

Calculating Cost of Debt

• Long-term borrowing costs are used for all debts to ensure investments exceed rolled-over costs.

Risks and Cost of Debt Estimation

In this section, the speaker discusses the importance of maintaining consistency in currency when estimating the cost of equity and debt for a company. They also delve into using ratings to estimate the cost of debt for specific companies.

Estimating Cost of Debt Using Ratings

• Three companies in the sample are analyzed: TARTA Motors, Bookscape, Val Disney, and Doche Bank.

• Default spreads are added to risk-free rates to estimate costs of debt for Disney, Doche Bank, and Val.

• Converting US dollar cost of debt to nominal cost by considering inflation rates.

Generic Problem: No Ratings Available

• When ratings are unavailable, an interest coverage ratio is used to estimate ratings and costs of debt.

• Interest coverage ratio is explained as operating income divided by interest expense.

Interest Coverage Ratios and Synthetic Ratings

This section focuses on utilizing interest coverage ratios to determine synthetic ratings for companies without available ratings.

Interest Coverage Ratios Analysis

• Different companies show varying levels of safety margins through their interest coverage ratios.

• A lookup table is constructed based on actual rated companies' data for non-rated ones.

Synthetic Rating Determination

• Assigning synthetic ratings based on interest coverage ratios: examples include double-A rating for Disney and A-minus rating for TARTA Motors.

Cost of Capital and Cost of Debt Analysis

In this section, the speaker discusses the importance of understanding the cost of capital and cost of debt in financial analysis, emphasizing the significance of accurate ratings and tax considerations in determining these metrics.

Understanding Ratings Impact on Cost of Capital

• The precision of ratings in calculating the cost of capital is not crucial; being close to the actual rating is sufficient.

Incorporating Country Risk in Ratings

• Ratings agencies consider a company's location when assigning ratings, impacting synthetic ratings.

• The Brazilian company Val's higher synthetic rating compared to its actual rating reflects country risk not factored into the synthetic rating.

Computing After-Tax Cost of Debt

• After-tax cost of debt calculation involves adjusting pre-tax costs with tax benefits based on marginal tax rates.

• Interest deductions reduce effective interest costs, leading to lower after-tax debt costs for companies like Bookscape.

Calculating After-Tax Costs for Different Companies

This segment delves into computing after-tax costs for various companies by considering their actual ratings, default spreads, and marginal tax rates specific to each entity.

Determining After-Tax Costs for Specific Companies

• Disney's after-tax cost is influenced by its single A rating and a 36.1% marginal tax rate.

• DOA's after-tax Euro cost reflects Germany's 29.5% marginal tax rate.

• Val's after-tax debt cost accounts for Brazil's 34% marginal tax rate due to its A minus rating.

Finalizing Cost Analysis and Considerations

This part concludes the discussion on determining costs by addressing T Motors' unique situation and highlighting factors affecting country-specific debt calculations.

Addressing Unique Situations: T Motors Case

• T Motors' Indian origin necessitates factoring both company-specific default spread and India's country risk into its rupee-based debt cost.

Importance of Updated Default Spreads

• Default spreads are vital in estimating debt costs but require regular updates due to changing market conditions.

Practical Application Tips