Cost of debt is directly observable and is much easier to find (compared to cost of equity).

You can find cost of debt by looking at the YTM of Long Term debt issued by the company that you are trying to value or a similar company in the industry.

Eric, I don't really think that "market value of IB debt" has anything to do with cost of debt.

Am I wrong?

 

I am taking a high level valuation course. So I am valuing a LBO target. It is highly levered with more than 20 different bonds and notes (varying maturities and very different YTM - perhaps due to different terms and conditions). In this case, how can I accurately calculate the cost of debt? From class, the professor has told us to use a zero coupon bond, which I cannot find for my company. Since Sponsors usually exit within 5 to 6 years, the cost of debt will likely to drop significant when they IPO. I am using a long bond as the rf, shouldn't I also match the cost of debt to 10 years? What do you guys think? Any experienced banker willing help out?

 

If the firm 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 firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt.  If the firm is not rated, • and it has recently borrowed long term from a bank, use the interest rate on the borrowing or • estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt  The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation. citation: damodaran.com

that should help you out.

 

In practice it's very difficult to be precise, unless you got lucky and are dealing with a firm with a very simple capital structure that just recently issued debt and can just look at that rate directly.

But if you have a complicated capital structure, then it would be a nightmare to try to be precise. You really have to ask "The cost of what debt?" because every security is at a unique place in the stack and may have unique features. If you have a firm with debt at various OpCos and then debt at the HoldCo level, the risk and hence cost of those securities will likely be very different.

What I would do to get a good estimate in a normal scenario [a company in good standing, with little bankruptcy risk throughout any part of the corporate structure] is look at total interest / total market value of debt. If you are looking at Int / Face Value then your answer could be wildly off depending on how the market environment & the company's situation has changed since the debt was raised. In a normal situation like this, assuming you are getting the cost of debt in order to value the whole company on a consolidated basis, you care about the weighted average cost of debt across the entire firm, so this approach is reasonable.

If you have a distressed situation throughout any part of the organization [i.e. you could have an organization with a HoldCo that is healthy & has plenty of equity value, but a subsidiary in distress] then you'd have to be a lot more careful. At that point you'd want to value each piece of the organization individually, and I'd take the same approach [int / market value of debt] but for each part of the company, not on a consolidated basis.

Looking at the spreads for comps that recently raised debt, if you have very close ones, may also be useful particularly if the company you are looking at doesn't have debt that trades often or at all.

 
Best Response

How do the observed betas of the most comparable publicly traded companies look? Does the company with no debt have a lower beta that might offset the lack of debt in the capital structure if a WACC was built solely using inputs of this one company in particular?

On the debt side, you couple assume an average or median capital structure of the comparable companies for the purposes of assuming a target capital structure to lever/unlever with and set the weightings up for a WACC.

It might help to sensitize around the target capital structure, and the cost of debt based on an average cost of debt based on the credit ratings of the companies that carry debt. You could maybe ask your professor where you could find some old Moodys Baa rated debt yields for 2004, based on consideration of the credit quality of the comparable companies, if you don't have this information.

If these assumptions don't move the discount rate using 0.5% - 1.0% rounding, I'd cite the sensitivity and call it a day on that. Just what I would have done in school - don't get mad if you actually do that and it's not enough for your professor.

 

K he's right for implying that you might be on drugs. This whole chain of questions makes very little sense.

Are you doing a comps valuation or DCF? You refer to both, but they're totally separate analyses. Was the comparison just to go Kd? If so, why are you doing it at all? Is it for your leveraged Beta?

CAPM deals only with Ke. In fact, that is the end result. It has nothing to do with cost of debt. It takes into account D/E ratio, but not Kd. So, you're definitely confused there.

If you're looking for Kd comps and can't find any, you look at companies with similar liquidity, leverage and interest coverage ratios, and do it that way.

Honestly, I'm trying to be helpful. But the way you asked your question is very unclear and mixes and confuses topics and theories. Perhaps spend some more time to figure out the right questions so that we can help you more effectively.

“Success means having the courage, the determination, and the will to become the person you believe you were meant to be”
 

Also don't get stick stuck in the weeds on this one issue and forget about the cash flow side or all the other stuff you could mess up. For example, don't ignore the cash impacts of any D&A items or piks or anything if that's part of the IPO proposed capital structure, and make sure the basis for the discount rate matches the free cash flow you're trying to discount.

 

Hello,

Thank you for your feedback, I am quite suprised at the quick nature of responses I have received already...

Let me clarify my situation more clearly for you:

  • I am currently conducting a DCF valuation of a company on its 2004 IPO listing date.

  • In calculating the WACC, I have used the CAPM approach to calculate the Cost of Equity (Ke).

  • The Company that I am valuing under the DCF valuation method does not yield any form of long-term debt/non-current liabilities whatsoever, presenting a problem in terms of calculating the cost of debt (Kd) of the firm, as well as to represent debt in terms of the WACC calculation.

  • Thus, as an IPO valuation, I am unable to find a suitable Beta and Cost of Debt (Kd) and debt value for the firm.

Therefore, I have gone about a solution to the problem via the following means:

1/ I have conducted a comparitive/relative valuation between the company I am valuing and the most suitable competitor firm amongst its industry sector. In deducing which firm is most suitable/similar/correlative to the company I am conducting the DCF on, I have used a variety of factors including capital structure, market cap, revenue trends, company size, geographic segmentation, operations, net profits, margins etc to assess the similarities between FOUR other companies and the one that I am trying to conduct the DCF valuation on. Thus, I have deduced that "Company A" was most suitable.

In asking why I have done a comparitive/relative valuation, the main intention behind this was firstly to prove as a reasonability check for my DCF valuation upon completion, providing a cohesive alternative approach to the valuation, and most importantly with the intention of using the chosen company as a suitable proxy for the missing figures (Beta, cost of Debt (Kd), value of debt) that obviously I cannot get from my IPO companies data.

2/ I have come to a "roadblock" in respect of this, as "Company A" too does not yield any form of long-term debt/non-current liabilities either. Thus, leading me back to my initial problem i.e. there is no suitable proxy for debt and Kd of the firm. In exploring the long-term debt obligations of all FOUR companies within the competitor pool of the IPO company I am trying to value, I have come to notice that there were only TWO firms with long-term debt, however these were zero coupon convertible subordinate notes. These do not pay any interest whatsoever.

Therefore, I am stuck. I am unsure as to how to proceed in finding an appropriate proxy for the cost of debt for the firm, and calculating a target WACC. There was no direct inference made within the IPO company's prospectus as to the inclination of taking on debt in the near future. The closest thing in this regard was that the prospectus made a mention that the IPO company may seek to issue debt securitiies or obtain a credit facility. This was simply a 'one liner' and was not addressed or further elaborated upon whatsoever.

How would you go about deducing a suitable proxy/alternative for the debt value and Kd of the firm in order to calcuate its WACC? I know that there is no Kd, and thus I was inclined to calculate the WACC soley upon the basis of using equity only. Whilst this is the case in reality, I still feel that this wouldn't be the best approach, hence I am writing to you.

In terms of finding an appropriate Beta, I will run the regressions in accordance with the "Company A" as per the outcome of my comparitive/relative valuation.

Your help,support and guidance would be greatly appreciated.

Kindest regards,

A.

 

@"bigblue3908" I know that seems logical, but I'm not happy in doing so considering the level of research my masters entails. Surely there is an effective alternative that would yield a greater, more substantiative result?

 

You could try to find the average/median debt to capital ratio among your selected comps to conclude your company's target capital structure. If the value is 0% or near 0% then the effect of your Kd input will be minimal (so don't spend much time on it).

Personally, I tend to not care about the interest rates the comps are paying on their debt but rather the yield-to-maturity of the debt securities. I think YTM is a better proxy for a company's cost of debt. If you adopt this line of reasoning you can still use the data from the zero coupon bonds.

Hope that helps.

 

@"beepbeepimajeep3" thank you for your response. My only issue with using the interest rate or YTM's of those companies with debt is that after conducting the comparative valuation/relative valuation, those two companies do best "represent" as the most fitting proxy.

With mention to what @"TDSWIM" mentioned earlier, what about perhaps obtaining the credit rating of the firm and then finding a suitable proxy firm with the same credit rating (i.e. perhaps one of the firms which have the debt as mentioned) and then assessing what a suitable market premium would be?

 

@"Anon199121", I think that's a fine tactic. I have used Bloomberg to find indexes containing a narrow range of credit ratings and used median YTM values to help conclude an approriate Kd. One issue is that if your Target is a private company you will have to perform a synthetic credit rating analysis. Again, if your target capitalization has a small or negligible portion of debt then this would be a waste of time. Using the Baa rate is a good shortcut if this is the case.

 

@"beepbeepimajeep3" in terms of these indices chosen, how many would you say one should be looking at? in terms of deducing a suitable index for the firm's "market return", I could surely use the same index in terms of the above?

I am valuing the target company on its 2004 IPO listing date, however, its competitors (4 main competitors) are were all already publicly listed at this time...

 

I agree with most of the comments above. Check target capital structure by looking at D/V of comps. If that shows the D/V is close to zero, you can likely ignore the debt component of the WACC. However, I may have missed what industry the subject firm is in, because that can give you an indication of how reasonable a D/V=0 assumption is. Also, in calculating D, you may want to look into the PV of operating leases. That should be in the notes to the subject firm's financials statements.

In addition, if you have a non-trivial D/V ratio, you may want to find a synthetic credit rating. One approach you can try for your situation is to use Altman's Z-Score, which uses financial metrics. Then, you can use the YTM on a Bank of America Merrill Lynch or Barclays/Lehman Bond index of similar rating (there are also sector specific versions of the index which you can use if it is applicable). Each of these indexes have certain issues on reconstitution dates, but you likely can ignore that.

 

Thank you.

I have ran an Altman', however, it is extremely difficult to find a Chinese bond index that was around back during 2004? Does anyone perhaps have any advice on this?

 

They're not interchangeable.

The cost of debt is the rate that makes all the cash flows of the debt equal to its present value.

It's observable in here:

Say you get a loan of $100 from a friend and promise to repay $110 one year from now.

PV:100 PMT:0 N:1 FV:110 I:?

I = 10%

The PMT is the interest rate, where I is YTM.

 

Technically, you can price debt using the same CAPM that you price equity with - that is, you would determine what your debt beta should be and use CAPM to get a required return. No one does this, though. What you can do is look at comparable firms with similar capital structure and see how their debt is priced. In the real world you pick up the phone and call the DCM guys and they give you a number.

 

Why is everything capitalised?

Do what bankers do, play with it until you like the output.

"After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.” - David Tepper
 
Is it safe to assume, pretty much all company debt is in the form of corporate bonds and/or convertible bonds, and its not borrowed and owed to a bank or other institution.

No, its not safe to assume that at all. In fact, in many emerging markets the bulk of debt consists of bank debt since bond markets are immature.

Moreover, where is the information for rates on corporate bonds?

Bloomberg.

This may seem simple, but I am lost as to find out how to source what a company is paying on its debt, making impossible to complete my WACC calculations.

The information is almost always listed in the annual reports and is mandatory in 10-Ks in the US.

 

I could be completely wrong but in the first case, wouldn't it be right to base your discount on how much of each debt there is? The amount of 4% vs amount of 2% should matter a lot because the more aggressive way to display this would be something like a weighted average of the borrowing rate. The conservative way to approach it would be to put everything at 4% (since you're discounting at the 'true' borrowing rate- it may even depend when the 2% debt was borrowed, or how much other debt has been borrowed previously).

I have no idea what you do in the second case and would be interested in hearing from someone who knows what they're talking about as well.

 

Ok, thanks but the teacher told us that we can not take the average current yield on the loans. He just said that we have to compute it in this way: Interbank interest rate + Credit spread. He also told us that we can find the credit spread on bloomberg....but where? It's correct if I take the 5years CDS?? Thanks again.

 

Bank loans are priced on (base rate + spread).

Base rate = EURIBOR Spread = credit spread

Find the loan on bberg, hit DES, and see what the pricing was. It looks something like: E+300. The 300 implies a 3% credit spread.

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Kekko147:

Thank you, but how is calculate it? I mean, how can I estimate the credit spread knowing the rating of my company?! Are the CDS a good approximations? thanks!

Gotcha. I re read your question. Didn't notice you were forced to use cds.

The command in bberg is either CDSW or CDWS. I forget which. It should show you the credit spread curve. You need to make a time horizon assumption (say 5yrs), then find the 5yr mark on the visualized curve. The other axis is your credit spead for each time horizon

Array
 

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