HURDLE

RATES IX: DEBT AND ITS

COST
Debt, the double-edged sword!

Set Up and Objective

1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate

4. Define & Measure Risk

5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights

The Financing Decision

Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations

Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing

Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends

36. Closing Thoughts

The Dividend Decision

If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business

Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game

Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

From Cost of Equity to Cost of Capital

The cost of capital is a composite cost to the rm of
raising nancing to fund its projects.
In addiNon to equity, rms can raise capital from
debt

What is debt?

General Rule: Debt generally has the following

characterisNcs:
Commitment to make xed payments in the future
The xed payments are tax deducNble
Failure to make the payments can lead to either default or

loss of control of the rm to the party to whom payments

are due.

As a consequence, debt should include

Any interest-bearing liability, whether short term or long

term.
Any lease obligaNon, whether operaNng or capital.

EsNmaNng the Cost of Debt

If the rm has bonds outstanding, and the bonds are traded,

the yield to maturity on a long-term, straight (no special
features) bond can be used as the interest rate.
If the rm is rated, use the raNng and a typical default spread
on bonds with that raNng to esNmate the cost of debt.
If the rm is not rated,

and it has recently borrowed long term from a bank, use the interest
rate on the borrowing or
esNmate a syntheNc raNng for the company, and use the syntheNc
raNng to arrive at a default spread and a cost of debt

The cost of debt has to be esNmated in the same currency as

the cost of equity and the cash ows in the valuaNon.
5

The easy route: Outsourcing the measurement

of default risk

For those rms that have bond raNngs from global raNngs agencies, I used
those raNngs:

Company
S&P Rating Risk-Free Rate Default Spread Cost of Debt
Disney
A
2.75% (US $)
1.00%
3.75%

Deutsche Bank
A
1.75% (Euros)
1.00%
2.75%
Vale
A2.75%c(US
1.30%
4.05%we can again use
If you
want to esNmate
Vales
ost $)of debt
in $R terms,

the dierenNal inaNon approach we used for the cost of equity:

A more general route: EsNmaNng SyntheNc

RaNngs

The raNng for a rm can be esNmated using the nancial

characterisNcs of the rm. In its simplest form, we can use
just the interest coverage raNo:
Interest Coverage RaNo = EBIT / Interest Expenses
For the four non-nancial service companies, we obtain the
following:
Company
Operating income Interest Expense Interest coverage ratio
Disney
$10.023
$444
22.57
Vale
$15,667
$1,342
11.67
Tata Motors
Rs 166,605
Rs 36,972
4.51
Baidu
CY 11,193
CY 472
23.72
Bookscape
$2,536
$492
5.16

Interest Coverage RaNos, RaNngs and Default

Spreads- November 2013

Disney: Large cap, developed

Vale: Large cap, emerging

Tata Motors: Large cap, Emerging
Baidu: Small cap, Emerging

Bookscape: Small cap, private

22.57

11.67

4.51

23.72

5.16

AAA


AA


A-


AAA


A-

8

SyntheNc versus Actual RaNngs: Rated Firms

Disneys syntheNc raNng is AAA, whereas its actual raNng is

A. The dierence can be abributed to any of the following:

SyntheNc raNngs reect only the interest coverage raNo whereas

actual raNngs incorporate all of the other raNos and qualitaNve factors
SyntheNc raNngs do not allow for sector-wide biases in raNngs
SyntheNc raNng was based on 2013 operaNng income whereas actual
raNng reects normalized earnings

Vales syntheNc raNng is AA, but the actual raNng for dollar
debt is A-. The biggest factor behind the dierence is the
presence of country risk, since Vale is probably being rated
lower for being a Brazil-based corporaNon.
Deutsche Bank had an A raNng. We will not try to esNmate a
syntheNc raNng for the bank. Dening interest expenses on
debt for a bank is dicult
9

EsNmaNng Cost of Debt

For Bookscape, we will use the syntheNc raNng (A-) to esNmate the cost of debt:

Default Spread based upon A- raNng = 1.30%

Pre-tax cost of debt = Riskfree Rate + Default Spread = 2.75% + 1.30% = 4.05%
Aler-tax cost of debt = Pre-tax cost of debt (1- tax rate) = 4.05% (1-.40) = 2.43%

For the three publicly traded rms that are rated in our sample, we will use the actual bond raNngs
to esNmate the costs of debt.

Company
S&P Rating Risk-Free Rate Default Spread Cost of Debt Tax Rate After-Tax Cost of Debt
Disney
A we have
2.75%
(US o$)f AA- from
1.00%
3.75% bond-raNng
36.1% rm, that m
2.40%

For Tata Motors,

a raNng
CRISIL, an Indian
easures
Deutsche
1.75%
1.00%
2.75%
29.48%
1.94%
only Bank
company rA
isk. Using
that (Euros)
raNng:
Vale Cost of debt =A1.30% + Default 4.05%
2.67%
Risk free r2.75%
ate (US
+ D$)
efault spread
spread 34%
TMT

Rupees

India

TMT

= 6.57% + 2.25% + 0.70% = 9.62%
Aler-tax cost of debt = 9.62% (1-.3245) = 6.50%

10

Updated Default Spreads January 2014

RaNng
Aaa/AAA
Aa1/AA+
Aa2/AA
Aa3/AA-
A1/A+
A2/A
A3/A-
Baa1/BBB+
Baa2/BBB
Baa3/BBB-
Ba1/BB+
Ba2/BB
Ba3/BB-
B1/B+
B2/B
B3/B-
Caa/CCC+

1 year
0.05%
0.11%
0.16%
0.22%
0.26%
0.33%
0.46%
0.58%
0.47%
0.95%
1.68%
2.40%
3.12%
3.84%
4.56%
5.28%
6.00%

5 year
0.18%
0.37%
0.55%
0.60%
0.65%
0.67%
0.84%
1.09%
1.27%
1.53%
2.29%
3.04%
3.80%
4.56%
5.31%
6.06%
6.82%

10 Year
0.42%
0.57%
0.71%
0.75%
0.78%
0.84%
1.00%
1.32%
1.52%
1.78%
2.59%
3.39%
4.20%
5.01%
5.81%
6.62%
7.43%

30 year
0.65%
0.82%
0.98%
0.99%
1.00%
1.12%
1.26%
1.67%
1.91%
2.18%
2.97%
3.77%
4.57%
5.36%
6.16%
6.96%
7.75%

11

6 ApplicaNon Test: EsNmaNng a Cost of Debt

Based upon your rms current earnings before

interest and taxes, its interest expenses, esNmate
An interest coverage raNo for your rm
A syntheNc raNng for your rm (use the tables from prior

pages)
A pre-tax cost of debt for your rm
An aler-tax cost of debt for your rm

12

Task
EsNmate the
cost of debt
for your
company

13

Read
Chapter 4

Chapter 4