Costs of Debt and Equity

Can the cost of equity ever be lower than the cost of debt for any firm at any stage in its life cycle?

Estimating the Default Risk and Default Spread of a firm

The simplest scenario for estimating the cost of debt occurs when a firm has long-term bonds outstanding that are widely traded. The market price of the bond, in conjunction with its coupon and maturity can serve to compute a yield we use as the cost of debt. For instance, this approach works for firms that have dozens of outstanding bonds that are liquid and trade frequently.

Many firms have bonds outstanding that do not trade on a regular basis. Since these firms are usually rated, we can estimate their costs of debt by using their ratings and associated default spreads. Thus, Disney with a BBB+ rating can be expected to have a

Default Risk: This is the risk that a firm will fail to make obligated debt payments, such as interest expenses or principal payments.

cost of debt approximately 1.25% higher than the treasury bond rate, since this is the spread typically paid by BBB+ rated firms.

Some companies choose not to get rated. Many smaller firms and most private businesses fall into this category. While ratings agencies have sprung up in many emerging markets, there are still a number of markets where companies are not rated on the basis of default risk. When there is no rating available to estimate the cost of debt, there are two alternatives:

• Recent Borrowing History: Many firms that are not rated still borrow money from banks and other financial institutions. By looking at the most recent borrowings made by a firm, we can get a sense of the types of default spreads being charged the firm and use these spreads to come up with a cost of debt.

• Estimate a synthetic rating and default spread: An alternative is to play the role of a ratings agency and assign a rating to a firm based upon its financial ratios; this rating is called a synthetic rating. To make this assessment, we begin with rated firms and examine the financial characteristics shared by firms within each ratings class. Consider a very simpler version, where the ratio of operating income to interest expense, i.e., the interest coverage ratio, is computed for each rated firm. In table 4.12, we list the range of interest coverage ratios for small manufacturing firms in each S&P ratings class48. We also report the typical default spreads for bonds in each ratings class.49

Table 4.12: Interest Coverage Ratios and Ratings

Interest Coverage Ratio

Rating

Typical default spread

> 12.5

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