Debt is not per definition bad as it can help your company finance profitable projects at a lower overall cost to the firm than if you use own equity.
Towards the concluding lines of Investment Decision (1): Hurdle Rate and Risk we already hinted that debt plays an important role in determining the hurdle rate. Even in Investment Decision (2): Hurdle Rate and CAPM, where we discussed how to estimate the cost of equity for a firm, the word debt was brought up in relation to levered and unlevered beta estimates. In this post we dig a little deeper in the topic.
What is Debt?
Debt is a deferred repayment of a sum of money. It is a legal commitment to make fixed payments which have the benefit of being tax deductible. On the flip side, failure to make payments can lead to default or loss of control of the firm.
Debt includes all short-term and long-term interest bearing liabilities such as loans or bonds. Perhaps surprisingly, it should also include any lease obligations as those obligations also match the definition of debt. After all, monthly rent is not only a (1) legal commitment to make (2) fixed payments but also impacts your (3) working capital. Furthermore, (4) failure to make payments may lead to loss of control of the firm.
The cost of servicing debt matters in two major decisions of corporate finance:
- Investment Decision: what is the cost of debt?
- Finance Decision: what is the optimal and right kind of debt?
In this post we will talk about the impact of debt on the investment decision and we’ll cover the finance decision in a different post.
Estimating the Cost of Debt
The first important note is that the cost of debt must always be calculated in the same currency as the cost of equity!
To estimate the cost of debt, there are several options:
- Yield to maturity on a long-term corporate bond as interest rate if the firm has issued bonds and those bonds are traded
- Default spread associated with a rating if the firm has a rating determined by an external rating agency
- Interest rate on a recent long-term borrowing if the firm has recently taken on a loan.
- Try to estimate a synthetic rating for the firm
Actual and Synthetic Ratings
During the financial crisis of 2008 the credit rating agencies received a lot of public attention. Nearly everyone now has heard about Standard & Poor’s and Moody’s. These two organizations are world leader in attributing ratings to all kinds of companies. The exact algorithm of the rating is unknown, so it is challenging to determine the actual rating for an unrated company.
Estimate a Synthetic Rating
However, we can estimate a synthetic rating by calculating the interest coverage ratio. The ratio is very simple. It calculates how many times the interest on a debt can be covered with the earnings of a firm.
Interest Coverage Ratio = (Earnings Before Income and Tax) / (Interest Expenses)
Using a reference table we can then determine a typical default spread for a company with a certain interest coverage ratio.
From Synthetic Rating to Cost of Debt
To determine the cost of debt from the synthetic rating, we return to the description of hurdle rate. The hurdle rate is the riskfree rate with added risk premium. In the case of a synthetic rate, we can say the cost of debt is then the riskfree rate + default spread associated with the synthetic rating. However, we should factor in that interest expense on debt is tax deductible. So,
- Pre-tax cost of debt = riskfree rate of local currency + default spread of synthetic rating
- After-tax cost of debt = (pre-tax cost of debt) x (1 – tax rate)
Be careful when using actual ratings from different rating agencies. Some may or may not include the country risk in their evaluation. That case, remember that the total risk for a firm is the sum of the riskfree rate, the country risk, and the firm risk.
Market Value of Debt
For the calculation of the cost of capital, it is preferred to use market value for both the cost of equity and cost of debt. For public companies, the market value of equity is determined by its stock prices. However, it’s a bit more challenging to determine the market value of debt.
One way to determine the market value of debt is to consider the entire debt as one coupon bond. The coupon payment is set equal to the interest expenses on all debt, and maturity set to the (face-value) weighted average maturity of debt. Then, it’s easy to calculate the present value of the annuity. Add to that the coupon bond at current cost of debt for the firm.
You can find an example by Mr. Aswath Damodaran here.
Market Value of Operating Leases
As mentioned, we should include any operating leases in the debt calculation. To calculate the value of the operating leases, simply calculate the present value of the lease payments at a rate that reflects their risk. This rate is usually the pre-tax cost of debt.