A brief discussion of common methods and their benefits.
Discounted cash flow analysis is a fundamental valuation technique that financial analysts, corporate development officers, and other financial professionals use around the world. It is highly sophisticated in its approach to company valuation, and such complexity carries with it a series of challenges. Specifically, the inputs needed to produce valuable results can be highly subjective. One of those inputs is the cost of debt. The cost of debt is part of the weighted average cost of capital calculation (WACC) that is used to discount future free cash flows of the company to the present. The challenge with the cost of debt is that there are many different ways to determine it, and most don’t bring a great level of transparency. This blog will discuss two differing ways to calculate the cost of debt and the overall strengths of each.
Current Cost of Debt Calculation
One of the most popular ways to determine the cost of debt is through a weighted average calculation of the yield to worst spreads for all outstanding debt issues of a particular company. Then, once determined, this number is multiplied by 1 minus the effective tax rate (income tax expense divided by pre-tax net income) for the company to obtain the after-tax cost of debt. This number is then plugged into the equation below to calculate the weighted average cost of capital.
Re = Cost of Equity
We = Percentage of Capital Structure that is Equity Funded
Rd = Cost of Debt
Wd = Percentage of Capital Structure that is Debt Funded
T = Corporate Tax Rate
The benefit of this method is that it is fairly simple and easy to perform. One of the biggest drawbacks occurs when securities aren’t traded regularly, which may cause stale data to influence the cost of debt calculation. Also, if a company doesn’t have a large number of debt securities, the cost of debt calculation could be less than effective. Ideally, a larger sample size of outstanding debt issuances is required to reduce the potential effect of outliers.
Cost of Debt Calculation Using Corporate Yield Curves
While the method discussed above is simple, another method to consider is one that utilizes corporate yield curves. The cost of debt can be determined by selecting the currency, sector, credit rating and tenor of the outstanding debt for a company. Besides its simplicity, this method also combines market transparency with comparable debt issues in an industry. It also reduces the chances of stale pricing affecting the cost of debt calculation. See Exhibit A for an example of the weighted average cost of capital calculation, and Exhibit B for an in-depth look at the newly released S&P Global Market Intelligence corporate yield curves for AT&T.
While there are many different ways to determine the cost of debt, the corporate yield curve is just another option available in our models to consider. It has a level of market transparency that isn’t readily available through a weighted average calculation. Financial analysts and corporate development professionals need this information to help make decisions when building their valuation models. As many say in finance, valuation is both an art and a science. S&P Global Market Intelligence provides the necessary tools to facilitate analysis enabling our clients to make informed decisions.