I have a couple of questions pertaining to calculating Cost of Debt while doing a DCF for a private company based on the projections provided by its internal finance team.
The company has a bunch of preferred financing.
Series A preferred - 28mm (7.85% PIK rate)
Series B preferred - 19mm (7.3% PIK rate)
1) So should I include this in the cost of debt calculation for WACC or as part of Cost of Preferred ?
2) For calculation of the company's Debt/Equity composition, should this preferred be considered as Debt or as Equity ?
3) When calculating the WACC, is it more accurate to take the median of the Debt/Equity of comparable public comps of the private company or just use the Debt/Equity numbers provided in its business plan ?

Also the company has a term loan for \$75mm and letter of credit for \$37mm. The term loan has a 7.5% interest rate while the letter of credit has a interest rate of 4.5%. Should I include the letter of credit in the cost of debt calculation ?

I have a tight deadline so any thoughts/advice would be really appreciated.

1) Is this "debt" contractually or structurally subordinated to all other debt?
2) Is it PIK for life or is there a cash component to it?
3) Is the final maturity well beyond all other debt maturities?
4) Is the instrument non-redeemable or transferable?

If it matches this I would say treat it as equity. If, however, it is:
1) marketable and transferable
2) has a large size relative to the rest of the company's capital structure

I would treat it as debt.

Term loan and revolver are senior secured loans I'm guessing? I would include them in the debt calculation.

if you are trying to come up with a fair market valuation, then you would not calculate WACC based on the specific debt/equity structure of the company. You would calculate WACC based on the likely capital structure of a market participant.

I've seen a similar case where we had group that owned preferred equity that paid part cash, part PIK. In determining how to classify this security, we based our decision on whether or not the preferred would be considered tax shielded by the IRS. It wasn't, so we treated it as equity.

There are a few tax law cases revolving around debt vs. equity classifications. Here are a few of the factors that the judge ruled as a determinant of classificaiton:

(1) intent of the parties (2) identity between creditors and shareholders (3) participation in management (4) debt/equity ratio (5) risk inherent in the instrument (6) formal indicia of debt or equity in the instrument (7) subordination (8) voting power (9) provision for fixed payments (10) contingency of repayment obligation (11) source of payments (12) presence of fixed maturity date (13) provision for redemption (14) timing of advance with reference to the issuer's organization (15) convertibility; and (16) the ability of the issuer to obtain funds from outside sources.

Could you go into a little more about the nature of your preferreds?

Also, based on what you said, I'd include the letter of credit.

Hi thanks for all the inputs so far. I was looking at the income statement and the interest on preferred is hitting the pretax line (so it is tax deductible). So can that be an indication to view it as part of debt and not equity ?

3) When calculating the WACC, is it more accurate to take the median of the Debt/Equity of comparable public comps of the private company or just use the Debt/Equity numbers provided in its business plan ?

When calculating WACC you have to use the WACC calc on the cost of equity and cost of debt.
1) The cost of equity will be found using CAPM. So you will take the unlevered betas of the comps and then relever them through the cap structure of the company you are valuing. Take the equity beta you calculate and plug that into CAPM. Google Damodaran and find his equity risk premium (6.6% right now I believe) and risk free rate on the 10 yr T-bill.

2) The cost of debt should include preferred here. You can infer what a private company's credit rating would be by doing some googling and looking up attributes get you which rating and then choose a reasonable cost of debt or use what theyre paying on the preferred and term loan. Me, I'd use 7.5%.