Technical Question: Cost of Capital in 100% Debt Company

2.4%

weird question...how do you wipe out the equity in an LBO lol so sponsors lose their whole check from day 1 lol

depends on if the cost of financial distress is greater than the tax savings on debt. so it's pretty much > 2.4%

debt in this case is functioning as the first loss capital - i.e. equity. Although the market rate on debt might be 4%, I would guess that cost of debt would approach the cost of equity - and would say that the market rate of debt would be 10% - the company's after-tax cost would be - 10* (1-40% tax) = 6%

this explanation might help ...

http://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theorem

Again, maybe I'm missing something, but that explains how debt/equity ratios don't affect enterprise value, which doesn't have anything to do with the cost of capital.

i honestly think that an interviewer is assuming you are using the WACC, so 2.4% would be the correct answer but i guess you should clarify that in the interview.

Umm, on question 1, why didn't you ask him what the tax rate was?

I'm assuming it's because you didn't know how to do question 2.. and yes, 24/10 or 2.4% is correct.

I answered 2.4%, but I think I'm wrong. I have thought about it, and I think I have the correct answer, but I just want to see if anyone else comes up with it.

Or maybe 2.4% is actually correct to begin with.

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http://people.stern.nyu.edu/adamodar/pdfiles/country/levvalue.pdf

check out slides 44 onwards, and especially slide 45. As you increase leverage level to infinity D/E (or 100% debt financing), the riskiness of the company increases. In this case there is no equity, and as you can see mathematically when Damodaran computes it (check out the Hamada equation), the cost of debt approaches the cost of equity.

In that case, from the Company's perspective if debt is just called equity, and you get the tax benefits, the appropriate market-charged cost of debt should equate to the cost of equity for the company. Thus Kd * (1-t) = after-tax cost of capital for the company

I like to think of cost of capital for a company as what would be the marginal rate charged on an incremental dollar of capital.

Interesting. So . . . 2.4% was blatantly wrong?

i doubt an interviewer would expect you to know that tbh. My answer would probably be somewhere around the lines of "Since this company is 100% debt financed, the the weighted average cost of capital would only include debt, and therefore the cost of capital would be 4% times 1-40% resulting in a 2.4% cost of capital"

2.4% would have shown that you know how to apply the formula. I remember getting this question during undergrad banking recruiting a few years ago - and i think it was a relatively standard concept taught in corporate finance.

out of curiosity - jd - what was the answer you thought was right afterwards?

It's a stupid question. 2.4% is mathematically correct but in reality it should be the same as the cost of equity because, as another poster mentioned, the debt acts as equity.

Whoah, no need to get hostile.

Of course debt can trade over par. I didn't think anybody was questioning that. We all know the difference between book and market value.

But your solution doesn't make sense. If the debt is trading above par, the yield (and hence the cost of capital) would be lower, not higher. If you are arguing that debt in a 100% debt company should be treated like equity and take on a higher cost, one would expect the debt to trade below par, not above. This makes sense from an intuitive level. In order to entice investors to buy debt in an all-debt company, where he must accept equity-like risk, the debt would have to sell at a discount, not a premium.

Anyway, returning to the original query: if I answered 2.4%, how is the interviewer likely to have assessed my answer?

Shameless bump.

so just got back and saw the rest of the posts - a hypothetical situation posted was dividend recapping the company after buying it so that it is financed by 100% debt. Now in such a scenario - look at it from the lender's perspective - if they are at first risk of loss of capital (i.e. there's no equity cushion below them), then they should theoretically charge at least the cost of equity Ke (if not more considering the control rights attached to equity) in return for giving you the $100 loan.

I was approaching the question from that perspective - any incremental capital added would then be priced at Ke

Regarding the interview - like I said, I remember discussing this is in Advanced Corp. Fin in undergrad. Was asked this during the analyst interview - and the interviewer said "that's it" when I got it.

I agree with JD - look at any distressed company - as the market value of equity disappears, the subordinated tranches of debt start to trade way below par and are priced more like equity. If you think about interest rates charged for different tranches of the capital structure - i.e. mezz vs HY bonds vs senior loans etc. - you'll see that the more junior you are - the greater that specific slice of capital will cost.

In an LBO situation - the WACC doesn't really make sense due to the highly levered structure - and the APV is arguably a better valuation method to use (not really done in practice though - since you're just backing into expected IRRs in various scenarios).

Going back to JD's question - if I was interviewing, I would likely have pushed you on the logic of the answer. However, missing one question is not necessarily the end of the world for interview as long as you qualify / explain it.

Well, he didn't really push for explanation. He just moved on to brain teasers.

as an addon - when calculating WACC you should be looking at the market value of debt, equity, preferred etc. - this is the true measure of the capital at risk at different point in the cap structure

ah - yeah -- i am not really sure what the technical hurdle is at the Associate level. I have gotten a bunch of really weird technical stuff throughout my interviews. Brainteasers seems odd though.

guessing IB associate recruiting?

also - maybe if he just moved on, he thought you were right ..

I thought it was odd too. I've never been asked brain teasers before. Ever.

Cynically, I imagine he went to them because he thought I gave him a stupid answer to the cost of capital question and wanted to see if I had any worthwhile intelligence.

good luck man

I think the simple way of looking at (resulting in the 2.4% answer) is most likely what the interviewer was looking for (100% debt just simplifies things).

Alternatively, I could also see an answer that takes into account other factors (e.g. riskiness) as being relevant as well. Obviously hard to say over the internet, but I'm leaning toward the simple answer, though it can't hurt to mention other things that could affect the cost of capital.

CH, upon thinking about it, you are probably right. My guess is: 60% chance he wanted the simple, formulaic answer (just to see if I understand that the cost of debt is tax-affected), and 40% chance he wanted to test my understanding of theory.

Ok this is a long post and I didn't read through all the comments to see if there was a correct answer.

But the correct answer is it depends:

Graphically, the relationship between debt and wacc is non-linear but a parabolic one. The minimum point at the curve indicates the optimum capital structure of a company, If your company has not met its target capital structure, then taking on more debt is beneficial due to the realized tax benefits resulting from it (Lowers wacc)

However, once you move past the optimum capital structure, taking on additional debt has an adverse effect due to too much leverage (increases wacc).

So for this question, I would answer 2.4% if assuming the company is at its target capital structure (which is unrealistic), otherwise, with a 100% debt capital structure, I would answer that the cost of capital is at LEAST 2.4%.

Agree with mrb87, and going along the same lines of reasoning as Blackhawk Invoke Modigliani Miller here. Draw a picture of the WACC, cost of debt and equity as a function of leverage. In this scenario, your debt is extremely risky (as risky as equity) since an operating loss will mean that the company cant make its required payments. As the company earns profits, there is equity created, at which point you can try using WACC. You'll see that the debt is still risky (but less risky than before), but the cost of equity is high teens, low twenties or so.