Actual and Synthetic Ratings

It is usually easy to estimate the cost of debt for firms that have bond ratings available for them. There are, however, a few potential problems that sometimes arise in practice:

• Disagreement between ratings agencies: While the ratings are consistent across ratings agencies for many firms, there are a few firms where the ratings agencies disagree with one agency assigning a much higher or lower rating to the firm than the others.

• Multiple bond ratings for same firm: Since ratings agencies rate bonds, rather than firms, the same firm can have many bond issues with different ratings depending upon how the bond is structured and secured.

53 To estimate the interest coverage ratio here, we added the operating lease expense back to both the numerator and the denominator:

Interest coverage ratio = (EBIT + Operating lease expense)/ (Interest expense + Operating lease expense) This is a conservative estimate of the rating. In reality, only a portion of the operating lease expense should be considered as interest expense. This, in turn, will increase the rating and improve the rating. In fact, the synthetic rating with this approach will be A.

• Lags or Errors in the Rating Process: Ratings agencies make mistakes and there is evidence that ratings changes occur after the bond market has already recognized the change in the default risk. It is a good idea to estimate synthetic ratings even for firms that have actual ratings. If there is disagreement between ratings agencies or a firm has multiple bond ratings, the synthetic rating can operate as a tie-breaker. If there is a significant difference between actual and synthetic ratings and there is no fundamental reason that can be pinpointed for the difference, the synthetic rating may be providing an early signal of a ratings agency mistake.

We computed the synthetic ratings for Disney and Aracruz using the interest coverage ratios:

Disney: Interest coverage ratio = 2,805/758 = 3.70 Synthetic rating = A-Aracruz: Interest coverage ratio = 888/339= 2.62 Synthetic rating = BBB While Disney's synthetic rating is close to it's actual rating of BBB+, the synthetic rating for Aracruz is much higher than it's rating of B-. The reason for the discrepancy lies in the fact that Aracruz has two ratings - one for its local currency borrowings of BBB- and one for its dollar borrowings of B+. We used the latter to estimate the cost of debt because almost all of Aracruz's debt is dollar debt. You can also consider the difference to be a reflection of the riskiness of Brazil as a country and the penalty that Aracruz pays for being a Brazilian company. In fact, we can quantify this difference by measuring the difference in interest rates (in US dollar terms) of Aracruz with the synthetic and actual ratings:

Cost of debt with actual rating of B- : 4% + 3.25% = 7.25%

Cost of debt with synthetic rating of BBB: 4% + 1.50% = 5.50%

Country default penalty attached to Aracruz debt = 7.25% - 5.50% = 1.75%

Retirement Planning For The Golden Years

Retirement Planning For The Golden Years

If mutual funds seem boring to you, there are other higher risk investment opportunities in the form of stocks. I seriously recommend studying the market carefully and completely before making the leap into stock trading but this can be quite the short-term quick profit rush that you are looking for if you am willing to risk your retirement investment for the sake of increasing your net worth. If you do choose to invest in the stock market please take the time to learn the proper procedures, the risks, and the process before diving in. If you have a financial planner and you definitely should then he or she may prove to be an exceptional resource when it comes to the practice of 'playing' the stock market.

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