N the two most widely used approaches to estimating

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n The two most widely used approaches to estimating cost of debt are: Looking up the yield to maturity on a straight bond outstanding from the firm. The limitation of this approach is that very few firms have long term straight bonds that are liquid and widely traded Looking up the rating for the firm and estimating a default spread based upon the rating. While this approach is more robust, different bonds from the same firm can have different ratings. You have to use a median rating for the firm n When in trouble (either because you have no ratings or multiple ratings for a firm), estimate a synthetic rating for your firm and the cost of debt based upon that rating.
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Aswath Damodaran 14 Estimating Synthetic Ratings n The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio Interest Coverage Ratio = EBIT / Interest Expenses n For Siderar, in 1999, for instance Interest Coverage Ratio = 161/48 = 3.33 Based upon the relationship between interest coverage ratios and ratings, we would estimate a rating of A- for Siderar. With a default spread of 1.25% (given the rating of A-) n For Titan’s interest coverage ratio, we used the interest expenses and EBIT from 2000. Interest Coverage Ratio = 55,467/ 4028= 13.77
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Aswath Damodaran 15 Interest Coverage Ratios, Ratings and Default Spreads If Coverage Ratio is Estimated Bond Rating Default Spread(1/99) Default Spread(1/01) > 8.50 AAA 0.20% 0.75% 6.50 - 8.50 AA 0.50% 1.00% 5.50 - 6.50 A+ 0.80% 1.50% 4.25 - 5.50 A 1.00% 1.80% 3.00 - 4.25 A– 1.25% 2.00% 2.50 - 3.00 BBB 1.50% 2.25% 2.00 - 2.50 BB 2.00% 3.50% 1.75 - 2.00 B+ 2.50% 4.75% 1.50 - 1.75 B 3.25% 6.50% 1.25 - 1.50 B – 4.25% 8.00% 0.80 - 1.25 CCC 5.00% 10.00% 0.65 - 0.80 CC 6.00% 11.50% 0.20 - 0.65 C 7.50% 12.70% < 0.20 D 10.00% 15.00%
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Aswath Damodaran 16 Cost of Debt computations n Companies in countries with low bond ratings and high default risk might bear the burden of country default risk For Siderar, the rating estimated of A- yields a cost of debt as follows: Pre-tax Cost of Debt in 1999 = US T.Bond rate + Country default spread + Company Default Spread = 6% + 5.25% + 1.25% = 12.50% n The synthetic rating for Titan is AAA. The default spread in 2001 is 0.75%. Pre-tax Cost of Debt = Riskfree Rate + Company Default Spread+ Country Spread = 5.10% + 0.75% + 0.95%= 6.80%
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Aswath Damodaran 17 Synthetic Ratings: Some Caveats n The relationship between interest coverage ratios and ratings, developed using US companies, tends to travel well, as long as we are analyzing large manufacturing firms in markets with interest rates close to the US interest rate n They are more problematic when looking at smaller companies in markets with higher interest rates than the US.
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Aswath Damodaran 18 Weights for the Cost of Capital Computation n The weights used to compute the cost of capital should be the market value weights for debt and equity.
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