Cost of Debt and WACC
The cost of debt is the return that a company provides to its debtholders and creditors. When debtholders invest in a company, they are entering an agreement wherein they are paid periodically or on a fixed schedule. Bond agreements or indentures set up the schedule, the maturity date, call options if applicable, and any other relevant factors.
Bonds are considered a safer investment than stocks due to the set payment schedule (interest payments will not go down during a bad year) but also produce smaller returns (interest payments will not go up during a good year). Due to the added security, required debt returns are lower than those for stock returns.
Corporate bonds differ from Treasury bonds (government-issued) in the sense that they carry significantly greater default risk. A default happens when a firm fails to pay an interest payment to a bondholder. No matter how financially stable a firm appears, the risk of default is always a possibility.
Therefore, corporate debt investors demand a return that includes a premium over the risk-free rate. The premium acts as compensation for the additional risk of default with a corporate lender. The size of the premium (default spread) will reflect the debt investor’s perception of the default risk. The higher the perceived risk is, the higher is the demanded premium.
Debt finance offers the advantage of being a cheaper source of financing relative to equity. It provides the additional benefit that interest payments are tax-deductible (tax shield).
Estimating the default risk spread
The debt of most publicly traded companies is rated by rating agencies such as S&P, Moody’s, and Fitch. Using these debt ratings and their associated published default risk spreads, the cost of debt can be estimated using an appropriate risk-free rate. Issues arise for small or emerging companies whose debt is not rated. For these companies, the default risk premium can be measured by:
- Examining recent borrowing history
- Estimating a synthetic rating (do the work of a rating agency and create a score)
Some of the formulas used by a rating agency to assess default risk include the following key metrics:
Once the default risk premium has been estimated, it is added to an appropriate risk-free rate. This will yield a pre-tax cost of debt. However, the relevant cost of debt is the after-tax cost of debt, which comprises the interest rate times one minus the tax rate [rafter tax = (1 – tax rate) x rD].
Full cost of debt
Debt instruments are reflected in the balance sheet of a company and are easy to identify. However, the issue is with the definition of debt:
“A liability is an obligation resulting from a past transaction that leads to a probable future outflow of economic benefit.
Debt instruments are instruments issued as a means of raising funds other than those classified in/as shareholders funds.”
Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) is a firm’s cost of funds. The WACC is composed of the individual costs of capital for each provider of financing to the company, weighted by the relative size of their contribution to the pool of finance. To calculate WACC, one must consider:
- If all the costs of finance been calculated
- If WACC components should be weighted by book or market values
The formula for calculating WACC is as follows:
Are all financing obligations accounted for in the WACC calculation? The following are examples of liabilities that may be omitted from the WACC calculation because of accounting rules:
- Operating leases
- Special purpose vehicles
- Joint ventures and associates
- Net pension deficits
WACC weighting – Book or market value weightings
Balance sheet items are valued historically. They are outdated but consistent with accounting rules. It is argued that book value removes volatility but is non-representative of market conditions. Most firms use WACC at the market value weighting approach. However, there are several other possibilities:
Weighting proportions – Cost of Debt
Current market value
- This is empirically correct but the current position may be atypical and exposed to volatility
Optimum leverage ratio
- Using either Modigliani & Miller or an empirical model, it is possible to derive the optimal capital structure for the firm’s WACC. Determining optimum leverage is merely a matter of finding the optimal capital structure that trades off tax benefits with the added financial stress of debt.
Target leverage ratio
- Some firm’s board of directors may set an attainable leverage ratio and use this structure as their WACC weighting, even if they are not currently at that capital structure
- Some firms may use the average weights that company competitors use for WACC. However, events such as an IPO lack available data. There is a belief that a company’s capital structure will tend towards an average.
- If the WACC is partly built from an unleveraged and re-leveraged cost of equity, the weighting used in the WACC model should be consistent with the weightings used when re-leveraging the unleveraged beta.
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