# Estimation will use levered beta calculation 2

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Estimation will use levered beta calculation 2. Estimate the Cost of Debt at different levels of debt: Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase. To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest expense) 3. Estimate the Cost of Capital at different levels of debt 4. Calculate the effect on Firm Value and Stock Price.

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Aswath Damodaran 30 Ratings and Financial Ratios AAA AA A BBB BB B CCC EBIT interest cov. (x) 12.9 9.2 7.2 4.1 2.5 1.2 (0.9) EBITDA interest cov. 18.7 14.0 10.0 6.3 3.9 2.3 0.2 Funds flow/total debt 89.7 67.0 49.5 32.2 20.1 10.5 7.4 Free oper. cash flow/total debt (%) 40.5 21.6 17.4 6.3 1.0 (4.0) (25.4) Return on capital (%) 30.6 25.1 19.6 15.4 12.6 9.2 (8.8) Oper.income/sales (%) 30.9 25.2 17.9 15.8 14.4 11.2 5.0 Long-term debt/capital (%) 21.4 29.3 33.3 40.8 55.3 68.8 71.5
Aswath Damodaran 31 Synthetic Ratings n The synthetic rating for a firm can be estimated by Using one of the financial ratios specified above Using a score based upon all of the financial ratios specified above n If you use only one financial ratio, you want to pick the ratio that has the greatest power in explaining differences in ratings. For manufacturing firms, this is the interest coverage ratio. n If you want to use multiple ratios, you have to determine how you will weight each ratio in coming up with a score. One approach used is a multiple discriminant analysis, where the weights are based upon how well the ratios predict ultimate default. (Altman Z score is one example).

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Aswath Damodaran 32 Process of Ratings and Rate Estimation n We use the median interest coverage ratios for large manufacturing firms to develop “interest coverage ratio” ranges for each rating class. n We then estimate a spread over the long term bond rate for each ratings class, based upon yields at which these bonds trade in the market place. (We used a sampling of 5 corporate bonds within each ratings class to make these estimates)
Aswath Damodaran 33 Interest Coverage Ratios and Bond Ratings If Interest Coverage Ratio is Estimated Bond Rating > 8.50 AAA 6.50 - 8.50 AA 5.50 - 6.50 A+ 4.25 - 5.50 A 3.00 - 4.25 A– 2.50 - 3.00 BBB 2.00 - 2.50 BB 1.75 - 2.00 B+ 1.50 - 1.75 B 1.25 - 1.50 B – 0.80 - 1.25 CCC 0.65 - 0.80 CC 0.20 - 0.65 C < 0.20 D

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Aswath Damodaran 34 Spreads over long bond rate for ratings classes: February 1999 Rating Spread Interest Rate on Debt AAA 0.20% 5.20% AA 0.50% 5.50% A+ 0.80% 5.80% A 1.00% 6.00% A- 1.25% 6.25% BBB 1.50% 6.50% BB 2.00% 7.00% B+ 2.50% 7.50% B 3.25% 8.25% B- 4.25% 9.25% CCC 5.00% 10.00% CC 6.00% 11.00% C 7.50% 12.50% D 10.00% 15.00%
Aswath Damodaran 35 Current Income Statement for Boeing: 1998 Sales & Other Operating Revenues \$56,154.00 - Operating Costs & Expenses \$52,917.00 EBITDA \$3,237.00 - Depreciation \$1,517.00 EBIT \$1,720.00 + Extraordinary Income \$130.00 EBIT with extraordinary income \$1,850.00 - Interest Expenses \$453.00 Earnings before Taxes \$1,397.00 - Income Taxes \$277.00 Net Earnings (Loss) \$1,120.00 Adjusted Operating Income (for leases) = \$1,720 million + Imputed interest expense on operating lease debt = \$ 1,720 + \$31 = \$ 1,751 million

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Aswath Damodaran 36 Estimating Cost of Equity n To estimate the cost of equity at each debt ratio, we first estimate the levered beta at each debt ratio: β levered = β unlevered [1+(1-tax rate)(Debt/Equity)] n The levered beta is used in conjunction with the riskfree rate and risk premium to estimate a cost of equity at each debt ratio: Cost of Equity = Riskfree rate + Beta * Risk Premium
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