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    Cost of Debt Calculations PDF

    Uploaded by

    huka
    The document discusses four methods for calculating the cost of debt component of the weighted average cost of capital (WACC). 1) The yield to maturity approach uses current yields on all debt issues in the target capital structure. 2) The credit rating approach determines the company's implied credit rating based on debt-equity ratios, then uses yields on bonds with the same rating. 3) The synthetic rating method calculates an implied default spread based on interest coverage ratios and ratings tables. 4) The company report method uses historical interest rates from financial reports as a check. The example calculates ABC company's cost of debt as 8.5% using the synthetic rating method.

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    Cost of Debt Calculations PDF

    Uploaded by

    huka
    92 views2 pages
    The document discusses four methods for calculating the cost of debt component of the weighted average cost of capital (WACC). 1) The yield to maturity approach uses current yields on all debt issues in the target capital structure. 2) The credit rating approach determines the company's implied credit rating based on debt-equity ratios, then uses yields on bonds with the same rating. 3) The synthetic rating method calculates an implied default spread based on interest coverage ratios and ratings tables. 4) The company report method uses historical interest rates from financial reports as a check. The example calculates ABC company's cost of debt as 8.5% using the synthetic rating method.

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    Cost of Debt Calculations.pdf

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    The document discusses four methods for calculating the cost of debt component of the weighted average cost of capital (WACC). 1) The yield to maturity approach uses current yields on all debt issues in the target capital structure. 2) The credit rating approach determines the company's implied credit rating based on debt-equity ratios, then uses yields on bonds with the same rating. 3) The synthetic rating method calculates an implied default spread based on interest coverage ratios and ratings tables. 4) The company report method uses historical interest rates from financial reports as a check. The example calculates ABC company's cost of debt as 8.5% using the synthetic rating method.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    92 views2 pages

    Cost of Debt Calculations PDF

    Uploaded by

    huka
    The document discusses four methods for calculating the cost of debt component of the weighted average cost of capital (WACC). 1) The yield to maturity approach uses current yields on all debt issues in the target capital structure. 2) The credit rating approach determines the company's implied credit rating based on debt-equity ratios, then uses yields on bonds with the same rating. 3) The synthetic rating method calculates an implied default spread based on interest coverage ratios and ratings tables. 4) The company report method uses historical interest rates from financial reports as a check. The example calculates ABC company's cost of debt as 8.5% using the synthetic rating method.

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    STEP 10 – WACC - CALCULATE COST OF DEBT

    You can’t just go to a company’s annual report and capture their cost of debt for use in your WACC calculation. The
    cost of debt in the annual report is historical and may not reflect your choice of debt – equity mix in your WACC or
    the cost of debt in the future. You must find the company’s future cost of debt for the credit rating implied by the
    debt-equity mix in your WACC.

    METHOD 1: YIELD TO MATURITY APPROACH (ONLY FOR PUBLIC DEBT)

    Determine the Weighted average of current yields to maturity on all issues in the target capital structure. The yield
    to maturity incorporates the market’s expectations of future returns on debt and should be used instead of the
    coupon rate

    METHOD 2: CREDIT RATING APPROACH

    First determine the credit rating the company would have been given your assumed debt-equity mix. S&P,
    Moody’s and other credit rating services publish ratio guidelines for different credit ratings. The rating guideline
    change frequently, so check for the latest information. Once you have the credit rating, check Bloomberg for yield
    to maturity on publicly traded long term bonds with the same credit rating.

    Cost of Debt = Risk Free Rate + Spread

    The difference between company’s cost of debt and the benchmark rate (LIBOR/Government Bond) is called a
    Spread

    METHOD 3: SYNTHETIC RATING METHOD

    If the company bonds are not listed, then one must calculate the implied synthetic default spread.

    Cost of Debt = Risk Free Rate + Synthetic Default Spread

    Calculation of Synthetic Default Spread

     Calculate the interest coverage ratio = EBIT / Interest Expense.


     Derive the Synthetic default spread as per the table below.

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    High Market Cap firms Low Market Cap Firms
    Interest Interest
    Coverage Ratio Rating Spread Coverage Ratio Rating Spread
    > 8.5 AAA 0.75% > 12.50 AAA 0.75%
    6.50 -8.50 AA 1.00% 9.50 - 12.50 AA 1.00%
    5.50 - 6.50 A+ 1.50% 7.50 - 9.50 A+ 1.50%
    4.25 - 5.50 A 1.80% 6.00 - 7.50 A 1.80%
    3.00 - 4.25 A- 2.00% 4.50 - 6.00 A- 2.00%
    2.50 -3.00 BBB 2.25% 3.50 - 4.50 BBB 2.25%
    2.00 - 2.50 BB 3.50% 3.00 - 3.50 BB 3.50%
    1.75 - 2.00 B+ 4.75% 2.50 - 3.00 B+ 4.75%
    1.50 - 1.75 B 6.50% 2.00 - 2.50 B 6.50%
    1.25 - 1.50 B- 8.00% 1.50 - 2.00 B- 8.00%
    0.80 - 1.25 CCC 10.00% 1.25 - 1.50 CCC 10.00%
    0.65 - 0.80 CC 11.50% 0.80 - 1.25 CC 11.50%
    0.20 - 0.65 C 12.70% 0.50 - 0.80 C 12.70%
    < 0.20 D 14.00% < 0.50 D 14.00%

    Note – This is just a guideline table. However, you should check with your senior for the revised updated table.

    METHOD 4: COMPANY REPORT METHOD (SPOT CHECK!)

    From the Annual report / quarterly report find interest rate applicable on each debt. The cost of debt may be
    historical but it may provide a good double check.

    Interest Expense
    Cost of Debt =
    Average Debt

    COST OF DEBT CALCULATION FOR COMPANY ABC

    Using synthetic rating method, we have Interest coverage ratio = EBIT / Interest Expense

    Interest Expense for ABC company (small cap $257million) is 15; Interest coverage ratio = 50/15 = 3.33

    High Market Cap firms Low Market Cap Firms


    Interest Interest
    Coverage Ratio Rating Spread Coverage Ratio Rating Spread
    > 8.5 AAA 0.75% > 12.50 AAA 0.75%
    6.50 -8.50 AA 1.00% 9.50 - 12.50 AA 1.00%
    5.50 - 6.50 A+ 1.50% 7.50 - 9.50 A+ 1.50%
    4.25 - 5.50 A 1.80% 6.00 - 7.50 A 1.80%
    3.00 - 4.25 A- 2.00% 4.50 - 6.00 A- 2.00% Default spread for ABC company is
    Excel Beyond Excellence!

    2.50 -3.00 BBB 2.25% 3.50 - 4.50 BBB 2.25% 3.50%


    2.00 - 2.50 BB 3.50% 3.00 - 3.50 BB 3.50%
    1.75 - 2.00 B+ 4.75% 2.50 - 3.00 B+ 4.75%
    1.50 - 1.75 B 6.50% 2.00 - 2.50 B 6.50%
    1.25 - 1.50 B- 8.00% 1.50 - 2.00 B- 8.00%
    0.80 - 1.25 CCC 10.00% 1.25 - 1.50 CCC 10.00%
    0.65 - 0.80 CC 11.50% 0.80 - 1.25 CC 11.50%
    0.20 - 0.65 C 12.70% 0.50 - 0.80 C 12.70%
    < 0.20 D 14.00% < 0.50 D 14.00%

    Pre tax Cost of Debt = Risk Free rate + default spread = 5.0% + 3.50% = 8.50%

    Post tax cost of debt = 8.50% x (1-33%) = 5.70%

    Note – we have assumed Risk Free Rate to be 5.0%.(please see the detailed note below on risk free rate)

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