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Estimating the Cost of Debt for Opportunity Cost of Capital

Learn how to determine the cost of debt by searching for yield to maturity on company's long-dated debt and adding a default premium based on the company's debt rating.

jenniferfrank
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Estimating the Cost of Debt for Opportunity Cost of Capital

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  1. Chapter 11 Instructors: Please do not post raw PowerPoint files on public website. Thank you! The Opportunity Cost of Capital: The Cost of Debt

  2. Estimating the Cost of Debt • Search Bloomberg (or other financial databases) for the yield to maturity on the company’s long-dated, option-free debt. • To determine price and yield accurately, use only large trades (> $1 million). • If bonds do not trade, instead add a default premium to a benchmark rate. • The benchmark rate should be a long-dated local Treasury bond rate. • The default premium is based on the company’s debt rating. • If your company (or client) does not have a debt rating, then use a scoring model to estimate a rating.

  3. Yield to Maturity of Debt • When purchasing a bond, investors require compensation. The discount factor used to value a bond is known as its yield to maturity (YTM). • A bond’s yield to maturity (YTM) is dependent on two factors: • Factor #1: the bond’s time to maturity (duration) • Factor #2: the credit spread for default risk

  4. Home Depot: Pricing Example Home Depot Coupon 5.875 5.875 Bond, maturing 12/16/2036 Yield 5.865 Semiannual Discount Present Period Date Coupon Yield Factor Value 1 12/16/2010 2.9375 2.9325 1.0293 2.854 2 6/16/2011 2.9375 2.9325 1.0595 2.773 3 12/16/2011 2.9375 2.9325 1.0906 2.694 4 6/16/2012 2.9375 2.9325 1.1226 2.617 5 12/16/2012 2.9375 2.9325 1.1555 2.542 6 6/16/2013 2.9375 2.9325 1.1894 2.470 7 12/16/2013 2.9375 2.9325 1.2242 2.399 8 6/16/2014 2.9375 2.9325 1.2601 2.331 9 12/16/2014 2.9375 2.9325 1.2971 2.265 10 6/16/2015 2.9375 2.9325 1.3351 2.200 … … … … … … … … … … … … 50 6/16/2035 2.9375 2.9325 4.2425 0.692 51 12/16/2035 2.9375 2.9325 4.3670 0.673 52 6/16/2036 2.9375 2.9325 4.4950 0.654 53 12/16/2036 102.9375 2.9325 4.6268 22.248 Present value: 100.134 • To value a bond, use the annuity formula for coupon payments and present value for the face value. • Alternatively, use a spreadsheet to compute the present value of individual cash flows. • For U.S. bonds, coupons are paid twice a year. Therefore, the bond-equivalent yield must be divided by two for discounting semiannual cash flows.

  5. Method 1: Use Financial Database Home Depot Coupon 5.875 Maturity 12/16/2036 Rating BBB+/Baa1 Trade date Time Price Yield Size 6/18/2010 11:37:19 99.440 5.917 214K 6/18/2010 9:33:40 97.898 6.034 10K 6/18/2010 9:32:39 98.898 5.958 10K 6/17/2010 15:11:00 99.387 5.921 400K 6/17/2010 13:23:11 98.819 5.964 6K 6/17/2010 13:23:11 98.986 5.951 6K 6/17/2010 13:13:20 100.132 5.865 5,000K 6/17/2010 13:06:59 101.539 5.760 10K 6/17/2010 13:06:59 99.414 5.918 10K 6/17/2010 12:31:45 99.745 5.894 4,025K CUSIP: 437076AS1 • To find the yield to maturity for companies with liquid corporate debt, search for trading data on the company’s long-term bonds (greater than 10 years). • In the United States, corporate bond trades are reported to the National Association of Securities Dealers, through its Trade Reporting and Compliance Engine (TRACE) system. Only trades greater than $1 million dollars should be considered. • Consider trade data on bonds from Home Depot(2036 5.875 percent bond).

  6. Critical Issue: Liquidity Home Depot Procter & Gamble Coupon 5.875 Coupon 6.45 Maturity 12/16/2036 Maturity 1/15/2026 Rating BBB+/Baa1 Rating AA−/Aa3 Trade date Time Price Yield Size Trade date Price Yield Size 6/18/2010 11:37:19 99.440 5.917 214K 6/17/2010 12:32:21 122.615 4.424 4,925K 6/18/2010 9:33:40 97.898 6.034 10K 6/16/2010 12:43:32 117.291 4.853 550K 6/18/2010 9:32:39 98.898 5.958 10K 5/18/2010 9:20:09 114.965 5.054 10K 6/17/2010 15:11:00 99.387 5.921 400K 5/13/2010 13:27:48 113.385 5.190 10K 6/17/2010 13:23:11 98.819 5.964 6K 5/7/2010 9:10:40 117.670 4.829 25K 6/17/2010 13:23:11 98.986 5.951 6K 5/7/2010 9:05:00 119.170 4.706 25K 6/17/2010 13:13:20 100.132 5.865 5,000K 5/7/2010 9:05:00 117.670 4.829 25K 6/17/2010 13:06:59 101.539 5.760 10K 5/6/2010 15:36:04 116.575 4.919 25K 6/17/2010 13:06:59 99.414 5.918 10K 5/5/2010 11:21:49 111.250 5.378 50K 6/17/2010 12:31:45 99.745 5.894 4,025K 5/5/2010 11:21:49 110.875 5.411 50K CUSIP: 437076AS1 CUSIP: 742718BH1 • Not all long-dated bonds trade on a frequent basis. Consider Procter & Gamble’s 6.45 percent 2026 bond. The bond traded only a handful of times during a two-month period.

  7. Method 2: Add Default Premium to Benchmark • How large is the default premium? • The default premium depends on two statistics: • The probability and timing of default • The amount recovered by bondholders following default • A corporate bond’s yield to maturity depends on the benchmark rate (often government Treasury bonds or LIBOR) plus a default premium. YTM = Benchmark + Default Premium

  8. Term Structure of Interest Rates • Often a one-year loan and a 10-year loan will carry different yield to maturities, even if each loan is default free. • Long-term interest rates are an average of short-term rates. U.S. Treasury Yield Curve June 2010 YTM = Benchmark + Default Premium http://www.bloomberg.com/markets/rates/index.html http://stockcharts.com/charts/YieldCurve.html Source: Bloomberg

  9. The Credit Spread for Default Risk • When a bank (or investor) lends money, it worries that it will not be paid back. Will the borrower default? • In order to be compensated for default risk, lenders charge a premium over the default-free benchmark rate to risky customers. The higher the chance of default, the higher the premium will be. • Rating agencies, such as S&P and Moody’s, rate the default risk of most bonds (www.standardandpoors.com and www.moodys.com). YTM = Benchmark + Default Premium

  10. S&P and Moody’s Ratings AAA/Aaa AA/AaA/A BBB/Baa BB/Ba B/B CCC/Caa EXTREMELY STRONG capacity to meet its financial commitments. AAA is the highest issuer credit rating assigned by Standard & Poor’s. VERY STRONG capacity to meet its financial commitments. It differs from the highest-rated obligors only in small degree. STRONG capacity to meet its financial commitments but somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories. ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its commitments. ------ LESS VULNERABLE in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions that could lead to the obligor’s inadequate capacity to meet its financial commitments. MORE VULNERABLE to nonpayment than obligations rated BB, but the obligor currently has the capacity to meet its financial commitments on its obligations. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitments. CURRENTLY VULNERABLE, and is dependent upon favorable business, financial, and economic conditions to meet its financial commitments. Speculative Investment Grade

  11. Home Depot: Ratings Example • On July 5, 2007, Standard & Poor's ratings service lowered both the corporate credit rating on Home Depot Inc. to BBB+ from A+ and the CP rating to A-2 from A-1. At the same time, the ratings were removed from CreditWatch, where they had been placed on June 19, 2007, with negative implications following the company's announced plans to use $9.5 billion of net proceeds from the sale of HD Supply and the issuance of $12 billion of senior notes and cash to finance a $22.5 billion share repurchase program. The CreditWatch resolution follows the company's approval by the U.S. Federal Trade Commission to sell HD Supply to a consortium of private equity firms. The outlook is stable.

  12. The Credit Spread for Default Risk Yield to Maturity by Debt Rating 10 - Year Bonds, Monthly Average percent, 2009 Treasury 3.60 AAA 4.36 AA+ 4.44 AA 4.52 AA − 4.53 A+ 4.55 A 4.71 A − 4.91 BBB+ 5.24 BBB 5.33 BBB − 6.07 BB+ 6.99 BB 7.22 BB − 7.47 B+ 7.93 B 8.65 B − 8.99 • The lower the rating, the higher the required yield to maturity. • Extremely safe bonds trade at a small premium to Treasuries. • “Junk bonds” can easily yield more than 10 percent. But the yield is far from guaranteed! YTM = Benchmark + Default Premium

  13. Default Spreads over Time Yield to Maturity by Rating 14 12 10 Treasury AAA 8 BBB 6 BB 4 2 0 Jan - 95 Jan - 98 Jan - 01 Jan - 04 Jan - 07 Jan - 10 • Default spreads change over time. Default spreads rise during times of economic distress. During the financial crisis of 2008, junk bond spreads spiked from 2 percent to 12 percent.

  14. Method 3: Determining the Credit Rating • Predicting default is key to determining an appropriate credit rating. To this end, Edward Altman of New York University built a linear model that combines various financial ratios to build a Z-score. X1 = Working Capital/Total Assets X2 = Retained Earnings/Total Assets X3 = Earnings Before Interest and Taxes/Total Assets X4 = Market Value of Equity/Book Value of Total Liabilities X5 = Sales/Total Assets • When the Z-score falls below 1.81, the company has a 90 percent chance of becoming distressed within a year. For an online version, check out the Credit Analyzer.

  15. Z-Scores and Credit Ratings • Although rating agencies use a combination of both financial ratios and quantitative assessments, the Z-score can be successfully mapped back to ratings. • As Z-scores rise, so do average bond ratings.

  16. Is the Z-Score Still Relevant? Default Expert Altman Launches Credit Rating Tool Default expert Edward Altman is teaming with RiskMetrics Group to offer credit ratings on North American companies, responding to a need for better default warnings in the wake of a record bankruptcy wave. “We are excited about it being a significant improvement over existing models that are out there and providing probability-of-default estimates that are very important to investors," said Altman, a professor of finance at New York University. Default probabilities are estimated with a "Z-Metrics" credit analysis tool, a new generation of the widely known Z-score formula introduced by Altman in 1968 to predict corporate defaults. “It's based on a much more up-to-date sample, many more new variables, and it includes market value variables as well as macroeconomic variables that the Z-score didn't," Altman said. "The accuracy level in terms of predicting defaults and nondefaults is considerably higher than both rating agencies and the old Z-score models," he said. —March 2010

  17. Determining the Credit Rating: Other Ratios Adjusted Key Industrial Financial Ratios, Long-Term Debt Three-Year (2005−2007) Medians Financial ratio AAA AA A BBB BB B CCC EBITDA/revenues (%) 22.2 26.5 19.8 17.0 17.2 16.2 10.5 Return on capital (%) 27.0 28.4 21.8 15.2 12.4 8.7 2.7 EBIT interest coverage (×) 26.2 16.4 11.2 5.8 3.4 1.4 0.4 EBITDA interest coverage (×) 32.0 19.5 13.5 7.8 4.8 2.3 1.1 Funds from operations/total debt (%) 155.5 79.2 54.5 35.5 25.7 11.5 2.5 Free operating cash flow/total debt (%) 129.9 40.6 31.2 16.1 7.1 2.2 −3.6 Debt to EBITDA 0.4 0.9 1.5 2.2 3.1 5.5 8.6 Debt/debt plus equity (%) 12.3 35.2 36.8 44.5 52.5 73.2 98.9 Source: Standard & Poor’s, CreditStats. • Market participants are keenly interested in what drives credit rating actions. Although agency models are proprietary, they have disclosed financial ratios they believe to be important:

  18. The Cost of Debt at Distressed Companies • Yield to maturity is not an expected return. It is the return earned if the obligation is paid on time and in full. Since distressed companies have a significant chance of default, the yield to maturity is a poor proxy for expected return. • One alternative for computing expected return is the capital asset pricing model (CAPM). Since most bonds don’t trade enough to generate a reliable beta, however, we compute index betas instead. • High-yield debt has only a slightly higher beta than investment-grade debt. • If the market risk premium equals 5 percent, this difference translates to only a 50 basis point differential in expected return! Beta by Bond Rating Asset class Treasury bonds Investment-grade corporate debt High-yield corporate debt Beta 0.19 0.27 0.37 Source: Lehman Brothers; “Global Family of Indices, Fixed Income Research”; Morgan Stanley Capital International; U.S. Treasury; Paul Sweeting.

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