Two questions regarding cost of debt...
Hi guys, hope you can help me out with this.
I read that Credit Default Swaps are used to get a credit spread to calculate cost of debt. How is this done? Does a CDS trading at 5$ with a loan of 100$ show a credit spread of 5% or is this calculated differently?
And can you explain, why this is a good estimate for credit spreads? Why do we actually do this approximation thingy and don't just look at a company's debt, look what it currently pays in interest, and calculate the cost of debt with brute force this way? Why go abstract?
Best regards, WVRHVMMER
Hi, I'll take a stab.
Last time I used CDS spread was when I tried to estimate a "country risk premium" for a South American country. Basically the thinking was the spread between said country's CDS and the U.S. CDS % is a good estimate. You can pull CDS premium/spread data from BBG. Otherwise, I'm not exactly sure how you calculate that % number. I used to know but now I forget.
Think about how CDS works for a second: we bet on something. If you win, I give you say 1 buck, and vice versa. It's a pretty generic bet because you can bet on pretty much anything using CDS. I think it's because of this "universal quality" that makes CDS spread a good estimate for the country risk premium.
And the risk premium goes to your WACC calculation. You can have that added to your cost of debt, or your cost of equity. In fact, I'd put that into CoE --- that seemed to be what I did back then.
I know I haven't explained everything but hope it's somehow helpful.
Your other question: why don't we do this? In fact people do this.
Say you have 5 tranches of debt, each with its own cost of debt and maturity. Then, to calculate the total cost of debt, you have a weighted average cost of debt where weight is your principal amount of debt.
You can have this "rolling cost of debt" line where you'll see your total cost of debt for the project/company at each time spot.
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