1. The Opportunity Cost of Capital: The Cost of Debt
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Chapter 11
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
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.
Home Depot
Coupon
5.875
5.875 Bond, maturing 12/16/2036
Yield
5.865
Semiannual
Discount
Present
Period
Date
Factor
Value 1
12/16/2010
2.9375
2.9325
1.0293
2.854 2
6/16/2011
1.0595
2.773 3
12/16/2011
1.0906
2.694 4
6/16/2012
1.1226
2.617 5
12/16/2012
1.1555
2.542 6
6/16/2013
1.1894
2.470 7
12/16/2013
1.2242
2.399 8
6/16/2014
1.2601
2.331 9
12/16/2014
1.2971
2.265 10
6/16/2015
1.3351
2.200 … 50
6/16/2035
4.2425
0.692 51
12/16/2035
4.3670
0.673 52
6/16/2036
4.4950
0.654 53
12/16/2036
4.6268
22.248
Present value:

5. Method 1: Use Financial Database
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 ( percent bond).
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
9:33:40
97.898
6.034
10K
9:32:39
98.898
5.958
6/17/2010
15:11:00
99.387
5.921
400K
13:23:11
98.819
5.964 6K
98.986
5.951
13:13:20
5.865
5,000K
13:06:59
5.760
99.414
5.918
12:31:45
99.745
5.894
4,025K
CUSIP:
437076AS1
Note: Insert Bloomberg Page on Next Slide.

6. Critical Issue: Liquidity
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.
Home Depot
Coupon
5.875
Procter & Gamble
6.45
Maturity
12/16/2036
1/15/2026
Rating
BBB+/Baa1
AA−/Aa3
Trade date
Time
Price
Yield
Size
6/18/2010
11:37:19
99.440
5.917
214K
6/17/2010
12:32:21
4.424
4,925K
9:33:40
97.898
6.034
10K
6/16/2010
12:43:32
4.853
550K
9:32:39
98.898
5.958
5/18/2010
9:20:09
5.054
15:11:00
99.387
5.921
400K
5/13/2010
13:27:48
5.190
13:23:11
98.819
5.964 6K
5/7/2010
9:10:40
4.829
25K
98.986
5.951
9:05:00
4.706
13:13:20
5.865
5,000K
13:06:59
5.760
5/6/2010
15:36:04
4.919
99.414
5.918
5/5/2010
11:21:49
5.378
50K
12:31:45
99.745
5.894
4,025K
5.411
CUSIP:
437076AS1
742718BH1

7. Method 2: Add Default Premium to Benchmark
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
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

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
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 ( and
YTM = Benchmark + Default Premium

10. S&P and Moody’s Ratings
AAA/Aaa
AA/Aa A/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
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!
3.60
4.36
4.44
4.52
4.53
4.55
4.71
4.91
5.24
5.33
6.07
6.99
7.22
7.47
7.93
8.65
8.99
Treasury
AAA
AA+ AA − A+ A
BBB+
BBB
BB+ BB B+ B
Yield to
Maturity by Debt Rating 10 -
Year Bonds, Monthly Average
percent, 2009
YTM = Benchmark + Default Premium

13. Default Spreads over Time
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. 2 4 6 8 10 12 14
Jan - 95 98 01 04 07
Yield to
Maturity by Rating
Treasury
AAA
BBB BB

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
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:
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
0.9
1.5
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.
Adjusted Key Industrial Financial Ratios, Long-Term Debt
Three-Year (2005−2007) Medians

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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