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Valuation: The cost of debt (WACC)

Valuation: The cost of debt (WACC)

 

From June until August 2019 I have written 6 blogs on business valuation and financial modelling in order to calculate enterprise value. These blogs are still available, you can find the links of the blogs at the very end of this blog.

 

In the upcoming months, I will write several blogs on the so called “Cost of Capital” that is used in business valuation.

 

I got inspired to do this after reading the book: “The real cost of capital: A business field guide to better financial decisions” (2004). The book is written by Tim Ogier & John Rugman & Lucinda Spicer.

 

Blogs in this sequence that I have published already (with the links);

 

-Valuation & Betas (CAPM)

https://www.linkedin.com/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/

 

-Valuation & Equity Market Risk Premium (CAPM)

https://www.linkedin.com/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/

 

-Is the Capital Asset Pricing Model dead ? (CAPM)

https://www.linkedin.com/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/

In this fourth one in the sequence I will talk about “the cost of debt” in relation to the WACC and valuation.

 

Consultant & Trainer: Joris Kersten

 

I am an independent M&A consultant and Valuator from The Netherlands.

 

In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world. This at (investment) banks, corporates and universities.

 

Also I provide inhouse training on request and I have two open training programs in business valuation in my home country The Netherlands.

 

At the very end of this blog you can find all information about my open training programs.

 

Introduction: The cost of debt

 

Essentially there are two sources of capital for a company: Equity and debt.

 

I have talked about equity before and when I have talked about debt, we can determine the weighted average cost of capital (WACC) of a company.

 

(in order to do that properly we need to take the right “capital structure” into account, this will be the topic of the blog after this one)

 

The WACC consists out of the cost of equity times the level of equity + the cost of debt (after tax) times the level of debt.

 

Characteristics of debt

 

Debt can take the form of loans, bonds and overdrafts.

 

In business applications when practitioners refer to the “cost of debt” they actually mean the “promised yield on debt”.

 

This means that in the event that a business to which an investor has lent money is successful (due to specific risk factors), the debt investor simply receives the contracted interest payments and the repayment of the principal.

 

But with using the promised yield they do not take into account the possibility of default. The promised yield taking default into account is called the expected yield.

 

In general this is not a problem since with for example business valuation (this is what I do) we mostly value companies “going concern”.

 

But technically we are overstating the true cost of debt and in the end the WACC.

 

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

 

Different types of debt

 

As mentioned, debt can take the form of loans, bonds and overdrafts.

 

Debt instruments have become much more complex in recent years and carry a variety of different terms.

 

The notes on the accounts of a company (from an annual report) will usually reveal a large array of debt instruments.

 

Treasury departments will use the money markets to raise short term funds or cover currency positions. And they use the bond markets to secure long term financing and cover cash flows in many currencies.

 

Some debt instruments are quite simple, but also more complex debt instruments are frequently used that include additional benefits like “options to convert” or subscribe for equity.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

 

The weighted cost of debt

 

When a company uses a wide variety of debt it is necessary to calculate the cost of debt for each individual instrument to establish the overall cost of debt.

 

This since you need to combine the costs of each individual instrument (proportionally), in order to calculate the weighted average cost of debt.

 

However, in practice it is easier to calculate an estimate of the “generic long term cost of debt” for a specific firm. And then consider whether any complex financial arrangements in place change the generic cost of debt.

 

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

 

Debt Margin

 

The pre-tax cost of debt can be expressed as:

 

Cost of debt = risk free rate + debt margin for default risk.

 

Investors providing debt to companies expose themselves to risk since companies can default on their obligations to lenders, whether they are banks or bondholders.

 

To compensate them for taking on this default risk lenders require a higher return for lending to a company rather than a government.

 

And this is known as the “debt margin”, which is the difference in the redemption yield on a corporate bond and the yield on a government bond (risk free rate).

 

In time, as the risk of corporate default increases, the returns required by investors also rise.

 

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

 

Calculation the debt margin: Direct methods

 

Debt margins can be calculated using information on bonds traded in the market.

 

Debt margins are the observed difference (“spread”) between the redemption yield on a government bond and the redemption yield on a traded corporate bond of comparable maturity.

 

For a company there are two direct ways in which debt margins can be calculated.

 

And later on indirect methods will be mentioned.

 

Direct methods:

 

First, you can look directly at the debt margins of traded corporate bonds issued by the company itself. Or you can look at first-hand information from the company itself about very recent borrowing margins on debt provided by third party banks.

 

Second, you can base the debt margins on other companies with traded debt, which are good close comparators to the company in question. Good comparators are companies in the same sector, equivalent size, financial health and gearing.

 

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

 

Calculation the debt margin: Indirect methods

 

Where debt margins cannot be directly measured from the market, then indirect methods can be used.

 

These estimate the cost of debt either by using credit ratings available in the market. Or by understanding the cause of default risk using financial analysis to estimate a “synthetic” credit rating.

 

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

 

Using a credit rating

 

Credit rating agencies analyse the projected financial performance of companies in order to assess their risks of default. And they provide a ranking from the safest to the least creditworthy.

 

Rating agencies examine complex quantitative and qualitative factors to assess their ratings for companies.

 

In some cases it is not possible to observe relevant corporate bonds directly.

 

For example, a business that has not yet started will not have issued bonds. Even if the business being examined has issued bonds these may not have the appropriate maturity dates.

 

In addition, it is sometimes more convenient to derive a broad benchmark of the cost of debt (a “generic cost of debt”, as mentioned earlier) for a company.

 

This rather than going to all the trouble of calculating the yields and interest rates on each of the company’s debt instruments separately. In order to combine them into a weighted average cost of debt.

 

In these cases it is possible to use credit ratings as the basis for evaluating a company’s debt margin. This without the need to observe the yields on its debt directly.

 

Credit ratings are intended to reflect the probability of default, and spreads widen with a higher risk of default. So there is a relationship between the observed market spreads and credit ratings.

 

Here fore you can find back on tables the averaged spreads observed in the market, by rating (and by different industries), on bonds varying in maturity.

 

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

 

Using a synthetic rating

 

Where no credit rating is available for the specific company some financial analysis is needed.

 

Analysis of the financial ratios of the company and financial ratios associated with specific ratings can provide a shortcut to get a sensible rating.

 

So with some knowledge on the key financial ratios of a company and information on the average ratios for a specific rating, it is possible to get a credit rating for a company.

 

This in order to derive an estimate of the debt margin.

 

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

 

Next blog next week

 

In hope you liked this blog on the “cost of debt” in the WACC. 😊

 

In my next blog, next week, I will talk about the “capital structure” to use in the WACC.

 

And when you have any questions in the meantime do not hesitate to contact me on: joris@kerstencf.nl

 

Sources used for this blog

 

· The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer. 9780273688747.

This book is fantastic and very practical, just a pleasure to read for every investment professional. Highly recommended! 😊

 

Training Calendar on Business Valuation of Joris Kersten:

 

In case you like additional in class training:

 

In my home country The Netherlands, and abroad, I provide open training programs in “Business Valuation” and “Financial Modelling”.

 

The next sessions are given below:

 

1. Business Valuation & Deal Structuring (6 day training): 18, 19, 20, 21 and 23, 24 March 2020 @ Uden in the South of The Netherlands;

2. Financial Modelling in Excel (4 day training): 20, 21, 22, 23 April 2020 @ Uden in the South of The Netherlands;

3. Financial Modelling in Excel (5 day training): 2, 3, 4, 5, 6 February 2020 @ Riyadh in Saudi Arabia.

 

All info on these open training sessions can be found on: www.kerstencf.nl/training

 

And 130 references on my training sessions can be found on: www.kerstencf.nl/referenties

 

Trainer & Consultant: J.J.P. (Joris) Kersten, MSc BSc RAB

 

· 130 recommendations on his training can be found on: www.kerstencf.nl/referenties

· His full profile can be found on: www.linkedin.com/in/joriskersten

 

J.J.P. (Joris) Kersten MSc BSc RAB (1980) is owner of “Kersten Corporate Finance” in The Netherlands, under which he works as an independent consultant in Mergers & Acquisitions (M&A’s) of medium sized companies.

 

Joris performs business valuations, prepares pitch books, searches and selects candidate buyers and/ or sellers, organises financing for takeovers and negotiates M&A transactions in a LOI and later in a share purchase agreement (in cooperation with (tax) lawyers).

 

Moreover, Joris is associated to ‘AMT Training London’ for which he provides training as a trainer and assistant-trainer in Corporate Finance/ Financial Modelling at leading investment banks in New York, London and Hong Kong.

 

And Joris is associated to the ‘Leoron Institute Dubai’ for which he provides finance training at leading investment banks and institutions in the Arab States of the Gulf.

 

In addition, Joris provides lecturing in Corporate Finance & Accounting at leading Universities like: Nyenrode University Breukelen, TIAS Business School Utrecht, the Maastricht School of Management (MSM), the Luxembourg School of Business and SP Jain School of Global Management in Sydney.

 

Moreover, he provides lecturing at partner Universities of MSM in: Peru, Surinam and Mongolia. And at partner Universities of SP Jain in Dubai, Mumbai and Singapore.

 

Joris graduated in MSc Strategic Management and BSc Business Studies, both from Tilburg University. In addition, he is (cum laude) graduated as “Registered Advisor Business Acquisitions” (RAB), a 1-year study in the legal and tax aspects of M&A’s. And Joris obtained a degree in “didactic skills” (Basic Qualification Education) in order to lecture at Universities.

 

Currently Joris is doing the “Executive Master of Business Valuation” to obtain his title as “Registered Valuator” (RV) given out by the “Netherlands Institute for Registered Valuators” (NIRV). This title will enable Joris to give out business valuation judgements in for example court cases.

 

J.J.P. (Joris) Kersten, MSc BSc RAB. Email: joris@kerstencf.nl. Phone: +31 6 8364 0527

 

Earlier blogs on “Business valuation to Enterprise Value”

 

From June until August I have written the following blogs on valuation:

 

1. Leveraged Buyout Analysis (LBOs);

 

2. M&A Analysis” (M&A model – Accretion/ Dilution);

 

3. Discounted Cash Flow Valuation (DCF);

 

4. Valuation Multiples 1 – Comparable Companies Analysis (comps);

 

5. Excel Shortcuts & Business Valuation;

 

6. Valuation Multiples 2 – Precedent Transaction Analysis.

 

You can find them on the links below:

 

1) LBO Analysis (June 9th 2019):

https://www.linkedin.com/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

 

2) M&A Analysis (June 20th 2019):

https://www.linkedin.com/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/

 

3) Discounted Cash Flow Valuation (July 24th 2019):

https://www.linkedin.com/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/

 

4) Valuation Multiples 1 – Comparable Companies Analysis (August 26th 2019):

https://www.linkedin.com/pulse/valuation-multiples-1-comparable-companies-analysis-joris

 

5) Excel Shortcuts & Business Valuation (August 28th 2019):

https://www.linkedin.com/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab

 

6) Valuation Multiples 2 – Precedent Transaction Analysis (August 19th 2019):

https://www.linkedin.com/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab

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