The Nuts and Bolts of how to calculate the Cost of Debt - A Review of Lecture 7 & 8 (Part 2)

After my short hiatus, a few more articles to cover the last several lectures.

The Cost of Debt

The cost of debt is defined as the rate at which you can borrow in current market conditions. The cost of debt is made up of two components: the cost reflected in the time value of money; and more importantly the cost of risk. There are four general approaches to calculating the cost of debt. Although it sounds like we have some choice, we are generally limited by the lack of prevailing market data. These four approaches include:

1. Assuming the firm debt is traded in a liquid market, calculating the yield to maturity.
2. Using a firm debt rating to estimate a default spread.
3. Using a scoring model to estimate the firm risk level which can then be used to estimate a default spread.
4. Use interest expense and a proportion of interest bearing debt as a proxy.

Although each of these methods is generally accepted, there are circumstances in which you should favour one over the other. Hopefully I will clear this up after I discuss each of the methods in some detail.

Option 1 - Find the Yield To Maturity

Basic arbitrage principles mean that the price of a bond is a function of the coupon, the yield to maturity, the duration of the bond, and its face value. Therefore, in solving for the cost of debt, if we are dealing with a stock that trades in a liquid corporate debt market, we can use this information to search for trading data based on the company's long term debt schedule (you will notice the use of the word LONG - just like with the return on equity we need to match duration on the debt side). Based on some sort of debt rating and maturity schedule, we can effectively, using first principles, derive a yield which serves as an appropriate proxy for the cost of debt. Calculating the yield will be slightly more complex with for floating rate bonds but similar principles should be used.

In the Australian market (or for most markets outside the US) using this technique is going to be limited by the fact that this debt is mostly of the private kind. We should remember though, that there are a whole range of Australian and international listed companies that go to the American market to raise debt.  This technique, therefore, should not be neglected just because we are dealing with firms outside the US.

Option 2 - Firm Debt Rating to Guide Default Premium

We already know that a corporate bond's yield to maturity is determined by some benchmark rate (risk free rate) + a default premium. The default premium is a function of two things:
1. The probability and timing of default - a high probability that is expected shortly means that the default premium should be high.
2. The amount received by bondholders following the default. If bondholders recieve 95c in the dollar after default, the default premium will not be as high if they are expected to recieve 4c in the dollar.

The benchmark can be deduced from a range of public sources (e.g. Bloomberg, Reuters, S&P etc..) which are updated quite frequently to reflect the markets expectation. Information regarding the default premium requires us to make an assessment of the firm (and the risk characteristics of its debt) from which we can refer to current market expectations of the premium over the default risk-free benchmark. You can also find this information from S&P, Moody's, Fitch. You will need to remember that the default rate varies through time, so you should always try and use the most current figures in your analysis.

Bonds are generally broken up into two categories - investment grade (AAA-BBB) and speculative grade (BB-CCC) - these are S&P ratings. AAA indicates very strong capacity to meet financial commitments and you would expect the premium over the default-free benchmark to be small. BB indicates that there are major ongoing uncertainties and exposure to some adverse business, financial and economic conditions. The top ASX 200 firms will operate somewhere between A and B. CCC indicates that a firm is very vulnerable.

Option 3 - Use a Scoring Model

The third method increasingly being adopted to approximately infer the cost of debt is the scoring model approach. This says that the cost of debt can be derived by questioning what is the risk of bankruptcy for the firm. Since the risk of bankruptcy is what drives the default premium this makes quite a lot of sense. While there are a number of ways to assess bankruptcy, one of the most commonly used methods in practice is the Altman Z-score. The Z-score is calculated in the following manner:

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5

T1 = (Current Assets-Current Liabilities) / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total Assets
T4 = Book Value of Equity / Total Liabilities
T5 = Sales/ Total Assets

These inputs can all be derived from your financial statements.If a z-score is less than 1.81 then the model predicts that there is a 90% chance that the firm will be distressed within a year. While this model and its predictive ability should not be treated as gospel, it serves a useful purpose. Empirical studies have shown a positive relationship to exist between Z-scores and bond ratings, which means that on average, this method will reflect the economic reality of the cost of debt. Calculating this by hand can be quite tricky, so excel modelling is preferred, but if you are really desperate then try this link

If you are not quite satisfied with the Z-score model, other ratios you may want to think about include EBITDA/Revenues, ROC, Interest Coverage Ratio, CF from Operations / Debt etc...

Option 4 - The Interest Expense Approach
This approach is simple to follow. Take interest expense for the last financial year and divide it by the level of interest bearing liabilities. It is a suitable proxy of the cost of debt if the firm has not become inherently more risky (by changing its operations), not borrowed more (thereby increasing its financial risk), and financial markets have not changed (i.e. become more volatile). If any of these three conditions are violated you will produce a figure that is inappropriate for your estimation of WACC. Why? The figures you are producing need to be forward looking numbers. What you have produced here reflects the past.


finc 3015 student said…
i find the cost of debt in this post particularly helpful and easy to understand. thank you, angelo.

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