D

20.00%

Source: Compustat and Bondsonline.com

Source: Compustat and Bondsonline.com

Now consider a private firm with $ 10 million in earnings before interest and taxes and $3 million in interest expenses; it has an interest coverage ratio of 3.33. Based on this ratio, we would assess a "synthetic rating" of BB for the firm and attach a default spread of 2.50% to the riskfree rate to come up with a pre-tax cost of debt.

By basing the synthetic rating on the interest coverage ratio alone, we run the risk of missing the information that is available in the other financial ratios used by ratings agencies. The approach described above can be extended to incorporate other ratios. The first step would be to develop a score based upon multiple ratios. For instance, the Altman Z score, which is used as a proxy for default risk, is a function of five financial ratios, which are weighted to generate a Z score. The ratios used and their relative weights are usually based upon past history on defaulted firms. The second step is to relate the level of the score to a bond rating, much as we have done in table 4.12 with interest coverage ratios. In making this extension, though, note that complexity comes at a cost. While credit or Z scores may, in fact, yield better estimates of synthetic ratings than those based only upon interest coverage ratios, changes in ratings arising from these scores are much more difficult to explain than those based upon interest coverage ratios. That is the reason we prefer the flawed but simpler ratings that we get from interest coverage ratios.

Short Term and Long Term Debt

Most publicly traded firms have multiple borrowings - short term and long term bonds and bank debt with different terms and interest rates. While there are some analysts who create separate categories for each type of debt and attach a different cost to each category, this approach is both tedious and dangerous. Using it, we can conclude that short-term debt is cheaper than long term debt and that secured debt is cheaper than unsecured debt, even though neither of these conclusions is justified.

The solution is simple. Combine all debt - short and long term, bank debt and bonds- and attach the long term cost of debt to it. In other words, add the default spread to the long term riskfree rate and use that rate as the pre-tax cost of debt. Firms will undoubtedly complain, arguing that their effective cost of debt can be lowered by using short-term debt. This is technically true, largely because short-term rates tend to be lower than long-term rates in most developed markets, but it misses the point of computing the cost of debt and capital. If this is the hurdle rate we want our long-term investments to beat, we want the rate to reflect the cost of long-term borrowing and not short-term borrowing. After all, a firm that funds long term projects with short-term debt will have to return to the market to roll over this debt.

Operating Leases and Other Fixed Commitments

The essential characteristic of debt is that it gives rise to a tax-deductible obligation that firms have to meet in both good times and bad and the failure to meet this obligation can result in bankruptcy or loss of equity control over the firm. If we use this definition of debt, it is quite clear that what we see reported on the balance sheet as debt may not reflect the true borrowings of the firm. In particular, a firm that leases substantial assets and categorizes them as operating leases owes substantially more than is reported in the financial statements.50 After all, a firm that signs a lease commits to making the lease payment in future periods and risks the loss of assets if it fails to make the commitment.

For corporate financial analysis, we should treat all lease payments as financial expenses and convert future lease commitments into debt by discounting them back the present, using the current pre-tax cost of borrowing for the firm as the discount rate. The

50 In an operating lease, the lessor (or owner) transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the lessor. Since the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement and the lease does not affect the balance sheet. In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a liability (for the lease payments) on the balance sheet. The firm gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each year. In general, capital leases recognize expenses sooner than equivalent operating leases.

resulting present value can be considered the debt value of operating leases and can be added on to the value of conventional debt to arrive at a total debt figure. To complete the adjustment, the operating income of the firm will also have to be restated:

Adjusted Operating income = Stated Operating income + Operating lease expense for the current year - Depreciation on leased asset In fact, this process can be used to convert any set of financial commitments into debt.

Book and Market Interest Rates

When firms borrow money, they do so often at fixed rates. When they issue bonds to investors, this rate that is fixed at the time of the issue is called the coupon rate. The cost of debt is not the coupon rate on outstanding bonds nor is it the rate at which the company was able to borrow at in the past. While these factors may help determine the interest cost the company will have to pay in the current year, they do not determine the pre-tax cost of debt in the cost of capital calculations. Thus, a company that has debt that it took on when interest rates were low, on the books cannot contend that it has a low cost of debt.

To see why, consider a firm that has $ 2 billion of debt on its books and assume that the interest expense on this debt is $ 80 million. The book interest rate on the debt is 4%. Assume also that the current riskfree rate is 6%. If we use the book interest rate of 4% in our cost of capital calculations, we are requiring the projects we fund with the capital to earn more than 4% to be considered good investments. Since we can invest that money in treasury bonds and earn 6%, without taking any risk, this is clearly not a high enough hurdle. To ensure that projects earn more than what we can make on alternative investments of equivalent risk today, the cost of debt has to be based upon market interest rates today rather than book interest rates.

Assessing the Tax Advantage of Debt

Interest is tax deductible and the resulting tax savings reduce the cost of borrowing to firms. In assessing this tax advantage, we should keep in mind that:

• Interest expenses offset the marginal dollar of income and the tax advantage has to be therefore calculated using the marginal tax rate.

After-tax cost of debt = Pre-tax cost of debt (1 - Marginal Tax Rate)

• To obtain the tax advantages of borrowing, firms have to be profitable. In other words, there is no tax advantage from interest expenses to a firm that has operating losses. It is true that firms can carry losses forward and can offset them against profits in future periods. The most prudent assessment of the tax effects of debt will therefore provide for no tax advantages in the years of operating losses and will begin adjusting for tax benefits only in future years when the firm is expected to have operating profits.

After-tax cost of debt = Pre-tax cost of debt If operating income < 0

Pre-tax cost of debt (1-t) If operating income>0

Illustration 4.12: Estimating the Costs of Debt for Disney et al.

Disney, Deutsche Bank and Aracruz are all rated companies and we will estimate their pre-tax costs of debt based upon their rating. To provide a contrast, we will also estimate synthetic ratings for Disney and Aracruz. For Bookscape, we will use the synthetic rating of BBB, estimated from the interest coverage ratio to assess the pre-tax cost of debt.

• Bond Ratings: While S&P, Moody's and Fitch rate all three companies, the ratings are consistent and we will use the S&P ratings and the associated default spreads (from table 3.4 in chapter 3) to estimate the costs of debt in table 4.13:

Table 4.13: Cost of Debt
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