Session 6: Cost of Debt and Capital

Introduction to Cost of Debt

In this session, we will discuss the basics of debt financing and how to determine the cost of debt.

Categorizing Debt

• Debt gives rise to contractual commitments that must be met in good times and bad.

• These commitments tend to be tax-deductible.

• If these commitments are not met, bad things happen to the company, such as default or loss of control.

• Interest-bearing debt, short-term and long-term bank loans, and corporate bonds meet these criteria for categorizing as debt.

Classifying Off-Balance Sheet Items as Debt

• Long-term lease commitments also meet the criteria for categorizing as debt since they are contractual commitments that are tax-deductible and can lead to bankruptcy if not met.

Determining the Cost of Debt

• The cost of debt is the rate at which a company can borrow money long-term.

• It is important to consider all interest-bearing debt and long-term commitments like lease payments when determining the cost of debt.

Understanding Cost of Debt

In this section, the speaker explains what cost of debt is and how to calculate it.

Key Components of Cost of Debt

• The cost of debt should include a risk-free rate plus a default spread.

• Default spread is the amount charged by banks or bondholders over and above the risk-free rate due to credit risk.

• If a company has a rating from S&P or Moody's, you can use that rating to estimate its default spread.

• If bonds are outstanding and publicly traded, you can look up the interest rate on those bonds.

Estimating Cost of Debt for Non-Rated Companies

• For non-rated companies, you can estimate their cost of debt by acting like a ratings agency and using financial ratios to come up with a synthetic rating.

• The interest coverage ratio (operating income divided by interest expenses) is one such ratio that can be used to estimate the synthetic rating.

• A lookup table based on rated companies' interest coverage ratios can be used to reverse engineer an estimated rating for non-rated companies.

Incorporating Country Risk into Cost of Debt

• When calculating cost of debt for companies in risky markets, it's important to consider both the default risk of the company and the default risk of the country in which it operates.

• To estimate country risk, you can add two-thirds of the country's sovereign CDS spread to your calculation.

Estimating the Cost of Capital

In this section, the speaker explains how to estimate the cost of capital for a company by combining the cost of equity and cost of debt. The weights used should be market value weights rather than book value weights.

Cost of Equity

• Start with the risk-free rate.

• Use a bottom-up beta that reflects the company's industry and exposure to country risk.

• Add a country risk premium and lambda to get the cost of equity.

Cost of Debt

• Estimate pre-tax cost to debt using an approach described earlier in the session.

• Compute tax benefit using marginal tax rate.

• Use after-tax cost of debt.

Weights for Debt and Equity

• Weights should reflect respective market values.

• Estimate market value for all debt using bond prices, book value, coupon rate, interest expenses, and maturity.

Overall Cost of Capital

• Weighted average of cost of equity and cost of debt is overall cost of capital.

• For hybrids like convertible debt or preferred stock, separate into conversion option in debt or use preferred dividend yield as its own element in your cost of capital.

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