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For instance, assume that the higher risk of small cap stocks comes from the higher operating leverage that these firms have, relative to their larger competitorsCost of Equity and a Small Firm Premium In chapter 6, we presented evidence of a small firm premium - small market-cap stocks earn higher returns than large market-cap stocks with equivalent betas. The magnitude and persistence of the small firm premium can be viewed as evidence that the capital asset pricing model understates the risk of smaller companies, and that a cost of equity based purely upon a CAPM beta will therefore yield too low a number for these firms. There are some analysts who argue that you should therefore add a premium on to the estimated cost of equity for smaller firms. Since small cap stocks have earned about 2% more than large cap stocks over the last few decades, you could consider this a reasonable estimate of the small firm premium. To estimate the cost of equity for a small cap stock with a beta of 1.2 (assuming a riskfree rate of 5.1% and a market risk premium of 4%), for instance, you would do the following: Cost of Equity for small-cap stock = Riskfree Rate + Beta * Market Risk Premium + Small Cap Premium = 5.1% + 1.2 * 4% + 2% = 11.9% We would introduce two notes of caution with this approach. First, it opens the door to a series of adjustments that you could make to the cost of equity, reflecting the numerous inefficiencies that we cited in chapter 6. For instance, you could estimate a low PE premium, a low price to book premium and a high dividend yield premium and add them all to the cost of equity. If our objective in valuation is to uncover market mistakes, it would be a mistake to start off with the presumption that markets are right in their assessments in the first place. Second, a better way of considering the small firm premium would be to identify the reasons for the premium and then develop more direct measures of risk. For instance, assume that the higher risk of small cap stocks comes from the higher operating leverage that these firms have, relative to their larger competitors. You could adjust the betas for operating leverage (as we did a few pages ago for Van Shoes) and use the higher betas for small firms. From Cost of Equity to Cost of Capital While equity is undoubtedly an important and indispensable ingredient of the financing mix for every business, it is but one ingredient. Most businesses finance some or much of their operations using debt or some security that is a combination of equity and debt. The costs of these sources of financing are generally very different from the cost of equity and the cost of financing for a firm should reflect their costs as well, in proportion to their use in the financing mix. Intuitively, the cost of capital is the weighted average of the costs of the different components of financing -- including debt, equity and hybrid securities -- used by a firm to fund its financial requirements. In this section, we examine the process of estimating the cost of financing other than equity and the weights for computing the cost of capital. Calculating the Cost of Debt The cost of debt measures the current cost to the firm of borrowing funds to finance projects. In general terms, it is determined by the following variables: (1) The riskless rate: As the riskless increases, the cost of debt for firms will also increase. (2) The default risk (and associated default spread) of the company: As the default risk of a firm increases, the cost of borrowing money will also increase. In chapter 7, we looked at how the default spread has varied across time and can vary across maturity. (3) The tax advantage associated with debt: Since interest is tax deductible, the after-tax cost of debt is a function of the tax rate. The tax benefit that accrues from paying interest makes the after-tax cost of debt lower than the pre-tax cost. Furthermore, this benefit increases as the tax rate increases. After-tax cost of debt = Pre-tax cost of debt (1 - tax rate) In this section, we will focus on how best to estimate the default risk in a firm and to convert that default risk into a default spread that can be used to come up with a cost of debt. Estimating the Default Risk and Default Spread of a firm The simplest scenario for estimating the cost of debt occurs when a firm has long term bonds outstanding that are widely traded. The market price of the bond, in conjunction with its coupon and maturity can serve to compute a yield that we use as the cost of debt. For instance, this approach works for a firm like AT&T that has dozens of outstanding bonds that are liquid and trade frequently. Many firms have bonds outstanding that do not trade on a regular basis. Since these firms are usually rated, we can estimate their costs of debt by using their ratings and associated default spreads. Thus, Boeing with a AA rating can be expected to have a cost of debt approximately 0.50% higher than the treasury bond rate, since this is the spread typically paid by AA rated firms. Some companies choose not to get rated. Many smaller firms and most private businesses fall into this category. While ratings agencies have sprung up in many emerging markets, there are still a number of markets where companies are not rated on the basis of default risk. When there is no rating available to estimate the cost of debt, there are two alternatives: 1. Recent Borrowing History: Many firms that are not rated still borrow money from banks and other financial institutions. By looking at the most recent borrowings made by a firm, we can get a sense of the types of default spreads being charged the firm and use these spreads to come up with a cost of debt. . Estimate a synthetic rating: An alternative is to play the role of a ratings agency and assign a rating to a firm based upon its financial ratios; this rating is called a synthetic rating . To make this assessment, we begin with rated firms and examine the financial characteristics shared by firms within each ratings class. To illustrate, table 8.5 lists the range of interest coverage ratios for small manufacturing firms in each S&P ratings class12. consider a small firm that is not rated but has an interest coverage ratio of 6.15. Based on this ratio, we would assess a synthetic rating of A for the firm. The interest coverage ratios tend to be lower for larger firms, for any given rating. Table 8.6 summarizes these ratios: This approach can be expanded to allow for multiple ratios and qualitative variables, as well. Once a synthetic rating is assessed, it can be used to estimate a default spread which when added to the riskfree rate yields a pre-tax cost of debt for the firm. Extending the Synthetic Ratings Approach By basing the rating on the interest coverage ratio alone, we run the risk of missing the information that is available in the other financial ratios used by ratings agencies. The approach described above can be extended to incorporate other ratios. The first step would be to develop a score based upon multiple ratios. For instance, the Altman Z score, which is used as a proxy for default risk, is a function of five financial ratios, which are weighted to generate a Z score. The ratios used and their relative weights are usually based upon empirical evidence on firm defaults. The second step is to relate the level of the score to a bond rating, much as we have done in the table above with interest coverage ratios. In making this extension, though, note that complexity comes at a cost. While credit or Z scores may, in fact, yield better estimates of synthetic ratings than those based upon interest coverage ratios, changes in ratings arising from these scores are much more difficult to explain than those based upon interest coverage ratios. That is the reason we prefer the flawed but simpler ratings that we get from interest coverage ratios. Estimating a Tax Rate To estimate the after-tax cost of debt, we consider the fact that interest expenses are tax deductible to the firm. While the computation is fairly simple and requires that we multiply the pre-tax cost by (1- tax rate), the question of what tax rate to use can be a difficult one to answer because we have so many choices. For instance, firms often report an effective tax rate, estimated by dividing the taxes due by the taxable income. The effective tax rate, though, is usually very different from the marginal tax rate, which is the rate at which the last or the next dollar of income is taxed. Since interest expenses save taxes at the margin (they are deducted from the last or the next dollar of income), the right tax rate to use is the marginal tax rate. The other caveat to keep in mind is that interest creates a tax benefit only if a firm has enough income to cover the interest expenses. Firms that have operating losses will not get a tax benefit, at least in the year of the loss, from interest expenses. The after-tax cost of debt will be equal to the pre-tax cost of debt in that year. If you expect the firm to make money in future years, you would need to adjust the after-tax cost of debt for taxes. We will return to this issue and examine it in more detail in chapter 10, where we will look at the same issue in the context of estimating after-tax cash flows. 8.10: Estimating the Cost of Debt: Boeing in June 2000 Boeing is rated AA by S&P. Using the typical default spreads for AA rated firms, we could estimate the pre-tax cost for Boeing by adding the default spread 13 of 1.00% to the riskless rate of 5%. Pre-tax cost of debtActual Rating = 5.00% + 1.00% = 6.00%% Boeing has an effective tax rate of 27% but we use a marginal tax rate of 35%, which is the federal marginal corporate tax rate to estimate the after-tax cost of debt for Boeing. After-tax cost of debt = 6.00% (1-.35) = 3.90% We could also compute a synthetic rating for Boeing, based upon its interest coverage ratio from 1999. Based upon its operating income of $1,720 million in 1999 and interest expense of $453 million in of that year, we would have estimated an interest coverage ratio: Interest coverage ratioBoeing = 1720/453 = 3.80 Using Table 8.6, we would have assigned a synthetic rating of A- to Boeing. Based upon default spreads prevailing in June 2000, this would have resulted in a default spread of 2.00% and a pre-tax cost of debt of 7.00% for the firm. Estimating the Cost of Debt for an Emerging Market firm In general, there are three problems that we run into when assessing the cost of debt for emerging market firms. The first is that most of these firms are not rated, leaving us with no option but to estimate the synthetic rating (and associated costs). The second is that the synthetic ratings may be skewed by differences in interest rates between the emerging market and the United States. Interest coverage ratios will usually decline as interest rates increase and it may be far more difficult for a company in an emerging market to achieve the interest coverage ratios of companies in developed markets. Finally, the existence of country default risk level hangs over the cost of debt of firms in that market. The second problem can be fixed fairly simply by either modifying the tables developed using U.S. firms or restating the interest expenses (and interest coverage ratios) in dollar terms. The question of country risk is a thornier one. Conservative analysts often assume that companies in a country cannot borrow at a rate lower than the country can borrow at. With this reasoning, the cost of debt for an emerging market company will include the country default spread for the country. Cost of debtEmerging Market company= Riskless Rate + Country Default Spread + Company Default SpreadSynthetic Rating The counter to this argument is that companies may be safer than the countries that they operate in and that they bear only a portion or perhaps even none of the country default spread. 8.11: Estimating the Cost of Debt: Embraer in December 2000 To estimate Embraers cost of debt, we first estimate a synthetic rating for the firm. Based upon its operating income of $810 million and interest expenses of $28 million in 2000, we arrived at an interest coverage ratio of 28.93 and an AAA rating. While the default spread for AAA rated bonds was only 0.75%, there is the added consideration that Embraer is a Brazilian firm. Since the Brazilian government bond traded at a spread of 5.37% at the time of the analysis, you could argue that every Brazilian company should pay this premium, in addition to its own default spread. With this reasoning, the pre-tax cost of debt for Embraer in U.S. dollars (assuming a treasury bond rate is 5%) can be calculated: Using a marginal tax rate of 33%, we can estimate an after-tax cost of debt for Embraer: After-tax cost of debt = 11.12% (1- .33) = 7.45% With this approach, the cost of debt for a firm can never be lower than the cost of debt for the country in which it operates. Note, though, that Embraer gets a significant portion of its revenues in dollars from contracts with non-Brazilian airlines. Consequently, it could reasonably argue that it is less exposed to risk than the Brazilian government and should therefore command a lower cost of debt. ratings.xls: This spreadsheet allows you to estimate the synthetic rating and cost of debt for any firm. |
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