in determining the cost of debt, a firm could use its yields and prices of outstanding bonds. This is a topic that many people are looking for. star-trek-voyager.net is a channel providing useful information about learning, life, digital marketing and online courses …. it will help you have an overview and solid multi-faceted knowledge . Today, star-trek-voyager.net would like to introduce to you Estimating The Cost Of Debt For WACC – DCF Model Insights. Following along are instructions in the video below:
“Guys so today. We re talking about calculating the cost of debt. And this is is something that you is usually done when you re calculating the discount rate. You use to value.
A company now a discount rate is an investor s desired rate of return generally considered to be the investors opportunity cost of capital and so say for example you re an investor and you re considering for investment options a b c. And d. If you decide to go with option b. There.
s an implicit opportunity cost that exists. When you forego options. A c. And b.
And the discount rate used to value future. Cash flows. Accounts for that opportunity cost that exists. When you choose to go with that respective investment option and the most common discount rate use is the weighted average cost of capital.
Which is the average cost of financing. A company s debt its two main sources of capital now to calculate the weighted average cost of capital. The whack formula is by multiplying the cost of equity by the proportion of equity to the total market value of capital plus. The after tax cost of debt times.
The proportion of debt to the company s total market value of capital and this makes sense like the weighted average cost of capital there are two sources of capital equity and debt you re looking at the respective costs and you re calculating the weighted average. So this formula is relatively simple to understand in this video. We re gonna be focusing on getting the after tax cost of debt number. Where does that number come from a lot of students will usually go to the financial statements and they ll calculate the percentage of interest paid versus the total obligations of that company and that s what they will use for that number.
But you ll actually see that there are a lot of assumptions that are excluded. There are four methods to calculating the cost cost of that the yield to maturity approach. The debt rating approach the synthetic rating approach and the use of the interest rate. Which i talked about already now if you can t find a cost of debt number through each of these three methods.
Only then should you be using the interest rate on bank debt because in the end when you look at banked and unbanked that is not publicly traded so the market value of that bank that is not available right it does not change. But when we re looking at the weighted average cost of cost of capital formula these weighted averages are the market value you of equity in the market value of debt relative to the market value of total capital. So it changes based on the economic conditions that exists in in the company s environment right. So you ll see that the fourth option is actually the most inaccurate option.
When it comes to estimating the cost of debt. Now. The first option is a yield to maturity approach and just a quick definition the ultimate rarity is the rate at which the current market price of the bond is equal to the present value of all the cash flows from the bond. And this is actually the best method to really estimate the current cost of that based on on the market value of that because in the end.
The yield to maturity is the current yield on that bond relative to its price. So. If the bond is trading below market value. It co to maturity will be higher than the coupon rate.
And if it s trading above face value. Then the seal to the maturity will be lower than the coupon rate and the three steps account to the to this approach are to first calculate the yield to maturity of all publicly traded company debt so the bonds that they have issued then calculate the weighted average of all debt instruments and then multiply that result by one minus the effective tax rate to get your after tax cost of debt now say for example. We re looking at apple s issued bonds thankfully enough morningstar provides this information to anyone all you have to do is google. It type in apple bonds and you ll find this this kind of dashboard and you can see here that actually there are a lot more bonds you can scroll down.
But essentially each bond. So this was it will take for. Example the first one so apple this. 24 percent coupon.
Bond it was issued they issued 55. Billion dollars of this bond. It is currently being traded at below face value. So it s trading at 98.
Dollars and 30 cents for every hundred. Dollars and it s fixed coupon is. 24 and its yield to. Maturity the current yield to maturity is 26.
9. Because once again the fate of the fate. At the bond is trading below face value now the ultimate surety approach essentially takes all of these bonds calculates. The way to deal to maturity and then it seems to be that is assumed to be the cost of that pre tax you multiply it with after the tax rate and then you get your after tax cost of that but for simplicity sake.
Let s take a look at an example where apple has three bonds they have a. 24 percent. Bond it won t coupon rate bond and a 46. 5 coupon rate bomb essentially what you have to do is.
Again. If this information is publicly available and this is their all their debt load. This is their entire debt load. Then you can just go on morningstar you can look at what the bond is currently trading at so this bond is trading in below face value below face value.
And this was actually trading at a premium. So above face value. Then you gen you then just calculate the the current market value of that debt of the. Bond so say for example for the first one the 24.
Percent coupon. It s trading at ninety eight dollars and thirty cents relative to a hundred dollars. So the discount rate would be zero point nine eight three and so you multiply that times five point five billion to get a five point four zero six five billion dollar market value for this existing bond and you do that for all three of these options to calculate the total market value of that which in this case would be thirteen point seven eight to five billion canadian dollars or us dollars. Whichever one you want to use now to calculate the yield to maturity and to calculate the average yield to maturity you need to calculate based on the weighted average.
So you would for the first bond you look at how much of it doesn t make up the entire market value of the company s debt. The second one how much is the weighting relative to total market value that and how much is a third one as well and then you take the existing yield to maturity. And you multiply the weighting by that yield to maturity to get a weighted yield to maturity for this respective company of 273. Percent so in this example.
If we re looking at these three bonds and these are the these are the only bonds and debt. Available to this company. Then the cost of that the pre tax cost of that would be set a two point seven three percent. You then just calculate one minus the effective tax rate.
Which in this case would be forty percent to get a after tax cost of that of one point six four percent. This is actually the most accurate method to estimate the current cost of that because again on a day to day basis. These bonds will change in value and therefore their yield to maturity will change in value thus. Reflecting the current cost of that this is the best the best and most accurate method to use now the method i like to use when i m personally building models is a debt rating approach and say for example in some cases.
The company the the company might have some bonds. But in my also have some bank debt so that the market information for that is not available in the end. It s between the company and the bank well in that case. Then you can kind of produce a proxy cost which kind of represents.
The base represents the cost of that based on the company s credit rating. So the formula for this is essentially you re adding. The default spread. Which is the default spread associated with that company s respective credit rating.
To the risk free rate and then multiplying it time by one minus the effective tax rate. And so the key to remember here is that the risk free rate. That we use is essentially the length of the bank debt or the the term of that bond that was issued. So say for example.
A company has a ten year bond or has a 10 year loan with a bank. Then you are using the 10 year. Treasury yield. In the end.
The risk free rate in any valuation will depend upon when the cash flow payment is expected to occur so that s really important that s something that you should apply. Whenever you are considering the risk free rate in addition to keep in the capital asset pricing model. I made a separate video on that and i also reference that so that s really important to remember it always occurs when the cash flow payment is expected to occur okay. So in this case.
Well take out to find the default spread. You look at for me. I took the moody s a benchmark and i looked at if it s the company s rated. It has a triple a credit.
Rating then the default spread is implied to be about 02. If the company has a triple c. Credit. Rating.
Then their implied default spread would be about 5. And so once you know the correct company s credit rating. You go to this benchmark. Which you can find on google.
And then you you take the default spread add it to the risk free rate. Which matches. The term length of the bond or the bank debt and then you multiply. It by 1 minus.
Team tax rate to get your after tax cost of that now let s look at an example consider abc corp. A national us retailer with a credit rating of 8 the company has a bank loan of 12 billion us dollars maturing in 11 years the effective tax rate reported in the most recent quarter was 33 percent and the current yield on a 10. Year treasury. Bond is 23.
Percent. Now the the now the bank loan is in 11 years. So. The principal is doing 11 years.
So taking the 10 year bond is the closest benchmark to really calculate the risk free rate. So in this case. That s why we chose the 10 year treasury bond. Which is currently yielding two point three eight percent.
So first the first step that we need to do is we need to find okay. So we know the credit rating is a we need to find the the company s default spread. So the default spread for a a a credit rating is one percent. We add that to the risk free rate of two point three eight percent and then multiply.
It by one minus. The effective tax rate of thirty three percent to get a count for abc corp. A after tax cost of debt of two point two seven percent. So that is the company s after tax cost of that this is relatively simple to do instead of just going on bloomberg and going on morningstar and calculating the weighted average yield to maturity you can kind of find a proxy by using the debt rating.
Approach and this is the one that i prefer to use now. I will also like to comment on an important consideration when using the debt rating approach you if the company is say for example you are a canadian or us. Investor. If the company is headquartered in emerging markets.
Or gets a lot of their revenues from emerging markets. Then you also have to consider a country spread. Because there are additional geopolitical risks that need to be factored and from both the cost of equity side. In addition from the cost of that side.
So you added a country spread. Which is essentially another benchmark you can go on google. You look at the country s current rating. The current credit rating for its local sovereign currency and then find the equivalent country spread for that and add that to your equation.
And the only thing that changes when you are calculating cost of debt for an emerging market kind of company is that you re adding the rest for a plus. The default spread plus. The country spread now so domestic companies you d only consider the these two the risk for in the default spread for emerging market countries for emerging market companies or companies that that get a lot of the revenues from that from those countries. You can you must also add the country spread now the third method is the estimate estimating the synthetic rating.
So the rating for a firm can be estimated using the financial characteristics of that firm the rating can be estimated from the interest. Coverage ratio. And so the interest. Coverage ratio is essentially the earnings before interest in tax.
So ebit divided by the companies in first expenses in that respective period. Once you determine your default spread you can use the credit rating approach to calculate the cost of that so what essentially what we have to do is we need to calculate if we don t know the credit rating of a company we can we can estimate and produce a synthetic rating by computing the interest. Coverage ratio. Looking at a bank benchmark to find the equivalent credit rating and then in putting that into our debt rating approach.
So here s a quick benchmark that i use this is provided by moody s and actually a new university also provides a similar example. So based on say for example. The company has a creditor interest coverage ratio of seven. So that s between six point five and eight point five then the equivalent the estimated bond rating for that company would be double a and so your defaults probably zero point five percent.
Say for example. If the company is doing. Very poorly and has an interest coverage ratio of 09. Then it would have an equivalent a bond rating of triple c.
Which adds a five percent default spread to the debt rating approach. Now once you find the equivalent and you produce that synthetic rating. Then you can calculate the default spread and just follow the same method. You did in your debt rating.
Approach so let s consider an example what is the cost of that for xyz corp. A brazilian. Manufacturer which recently reported ebit of seven point eight to seven million. Us.
Dollars. Xy is these interest expense was 1 million. Nine hundred and seventy two dollars. The effective tax rate was twenty seven percent.
The country spread was four point six percent and the relevant risk free rate was three point nine percent. So in this example. The first thing that we have to do is we need to calculate the interest coverage ratio for the company to determine the equivalent bond rating. For that respective company.
Then we asked me to synthetic rating. And then calculate the after tax cost of that using the debt rating approach that we did in our previous slides. So to calculate the interest coverage ratio. So the e bit for the company is seven point eight to seven million and divide that by 101 million nine hundred seventy two million and to get an interest coverage ratio of three point nine seven that is our interest coverage.
We then look at the benchmark that i provided in the earlier. Slides so three point nine seven will. Fall but three and 425 and so would have an equivalent bond rating of a which adds a one point two five percent default spread then we take that default spread. And we take all the irrelevant.
Information. Providing the question and then just apply the the debt rating approach. So we add our rest free rate. Which is three point nine percent.
The default spread. Which is one point two five percent and in this case because it s a brazilian. Manufacturer we also had the country spread of 46. To then get an after tax cost of debt of seven point.
One two percent. So the final method and this is the one unfortunate that a lot of people use. But again it does not change this this this cost of that will remain the same in whatever market. And that is inaccurate.
When you re calculating the existing market value of that debt. But this method considers how much interest. The company is paying for its existing obligations. It should only be used if the yield to maturity and debt rating approaches are not possible so you divide the interest expense by the firm s debt obligations short plus long term debt and then calculate the after tax of that and this is usually what a lot a lot of people do so consider.
An example abc corp. Has the following debt. So it has one long term obligation of 1 1. Million dollars has another long term obligation with two million in a short term obligation of 200 thousand.
This is the interest that they are paying on those on that bank debt and the total interest paid for that year and the total loan value so all their their total. Obligations and so essentially you just divide 200 in 2005 32. Million to get your your pre tax cost of that of six point one three one percent. Then multiply.
It by one minus. The effective tax rate to get our after tax cost of that of four point six one percent. This will not change so regardless of what the market is currently valuing their book their their potential bonds that if the company. Only has banked that the bank debt will not change.
And its interest will always be this and this therefore their cost of that will remain consistent with this which in some cases is okay if the company does not have a lot of bonds. But if the company does have ones and actually i ll make this know right now. So say for example. A company has issued one bond and has one a some bank debt.
If you can if if you can t calculate the debt rating. Then use the yield to maturity. Just go and look at the bond. Don t go to the bank debt and first consider the bond and consider the yield to maturity.
And what the market is current currently valuing their debt at because that will give you a much more accurate perspective of the company s cost of debt. Now aside. Know what is considered debt. Now that should be all interest bearing obligations short term as well as long term and in addition.
I ll make a separate video series on this it should also include the present value of commitments. Such as operating leases. So say for example you re looking at an airline company that leases out their planes. If you were to only include the company s long term and short term debt.
Then that would inaccurately display. The company s existing market value of that because you d have to capitalize the company s operating lease and then account for that as as debt. So i ll make a separate video on that. But it s important to remember.
When you re calculating the market value of that in total a market value of that is important to also consider the present value of commitments. Such as operating leases. So a quick overview the four methods to calculating the cost of them are the yield to maturity approach. The debt rating approach the estimating the synthetic rating and then applying the debt rating formula or the fourth one using the interest rate on bank debt other than that i hope you got hope.
This video was really helpful guys if you do have any questions or didn t understand some of the slides. Please comment below and i ll be sure to get back to you as as soon as possible other than that please like and subscribe to my channel. I really like making these videos and i can t wait to be helping out more people soon so have a great day guys. ” .
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