Chapter 6
Pre-tax cost of debt (or 'yield' to the debt holder)
In both the previous examples, the focus was on finding the post-tax cost of
debt, which is a key component in the company's WACC calculation.
In order to compute the pre-tax cost of debt (sometimes called the yield to the
investor, yield to maturity, or gross redemption yield) the method is very similar.
For irredeemable debt, the pre-tax cost of debt is simply I/MV.
For redeemable debt, the pre-tax cost of debt is the IRR of the bond price, the
GROSS interest (i.e. pre-tax) and the redemption payment.
In both cases, the only difference from the above calculations is that interest is
now taken pre-tax in the formulae.
Student Accountant article
The examiner's article 'Bond valuation and bond yields' in the Technical Articles
section of the ACCA website covers the calculation of bond yields in more
detail.
Credit spread
An alternative technique used in AFM for deriving cost of debt is based on an
awareness of credit spread (sometimes referred to as the 'default risk
premium'), and the formula:
kd (1–T) = (Risk free rate + Credit spread) (1–T)
The credit spread is a measure of the credit risk associated with a company.
Credit spreads are generally calculated by a credit rating agency and presented
in a table like the one below.
Credit risk, rating agencies and spread
What is credit risk?
Credit or default risk is the uncertainty surrounding a firm’s ability to
service its debts and obligations.
It can be defined as the risk borne by a lender that the borrower will
default either on interest payments, the repayment of the borrowing at the
due date or both.
The role of credit rating agencies
If a company wants to assess whether a firm that owes them money is
likely to default on the debt, a key source of information is a credit rating
agency.
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The weighted average cost of capital (WACC)
They provide vital information on creditworthiness to:
• potential investors
• regulators of investing bodies
• the firm itself.
The assessment of creditworthiness
A large number of agencies can provide information on smaller firms, but
for larger firms credit assessments are usually carried out by one of the
international credit rating agencies. The three largest international
agencies are Standard and Poor's, Moody's and Fitch.
Certain factors have been shown to have a particular correlation with the
likelihood that a company will default on its obligations:
• The magnitude and strength of the company’s cash flows.
• The size of the debt relative to the asset value of the firm.
• The volatility of the firm’s asset value.
• The length of time the debt has to run.
Using this and other data, firms are scored and rated on a scale, such as
the one shown here:
Fitch/S&P Grade Risk of default
AAA Investment Highest quality – zero risk
AA Investment High quality – v little risk
A Investment Strong – minimal risk
BBB Investment Medium grade – low but clear risk
BB Junk Speculative – marginal
B Junk Significant risk exposure
CCC Junk Considerable risk exposure
CC Junk Highly speculative – v high risk
C Junk In default – v high likelihood of failure
Calculating credit scores
The credit rating agencies use a variety of models to assess the
creditworthiness of companies.
In the popular Kaplan Urwitz model, measures such as firm size,
profitability, type of debt, gearing ratios, interest cover and levels of risk
are fed into formulae to generate a credit score.
These scores are then used to create the rankings shown above. For
example a score of above 6.76 suggests an AAA rating.
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Chapter 6
Credit spread
There is no way to tell in advance which firms will default on their
obligations and which won’t. As a result, to compensate lenders for this
uncertainty, firms generally pay a spread or premium over the risk free
rate of interest, which is proportional to their default probability.
The yield on a corporate bond is therefore given by:
Yield on corporate bond = Yield on equivalent treasury bond
+ credit spread
Table of credit spreads for industrial company bonds:
Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr
AAA 5 10 15 22 27 30 55
AA 15 25 30 37 44 50 65
A 40 50 57 65 71 75 90
BBB 65 80 88 95 126 149 175
BB 210 235 240 250 265 275 290
B+ 375 402 415 425 425 440 450
Examples of calculations of yield
Simple illustration
The current return on 5-year treasury bonds is 3.6%. C Co has equivalent
bonds in issue but has an A rating. What is the expected yield on C’s
bonds?
Solution
From the table the credit spread for an A rated, 5-year bond is 65.
This means that 0.65% must be added to the yield on equivalent treasury
bonds.
So yield on C’s bonds = 3.6% + 0.65% = 4.25%.
More advanced illustration
The current return on 8-year treasury bonds is 4.2%. X Co has equivalent
bonds in issue but has a BBB rating. What is the expected yield on X’s
bonds?
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The weighted average cost of capital (WACC)
Solution
From the table the credit spread for a BBB rated, 7-year bond is 126. The
spread for a 10-year bond is 149.
This would suggest an adjustment of
(149 – 126)
126 +
3
= 126 + 7.67 = 133.67
So 1.34% must be added to the yield on equivalent treasury bonds.
So yield on X’s bonds = 4.2% + 1.34% = 5.54%.
Test your understanding 5
The current 4-year risk free return is 2.6%. F Co has 4-year bonds in
issue but has an AA rating.
Required:
(a) calculate the expected yield on F’s bonds
(b) find F’s post-tax cost of debt associated with these bonds if the
rate of corporation tax is 30%.
(Use the information in the table of credit spreads above).
Test your understanding 6
Landline Co has an A credit rating.
It has $30m of 2 year bonds in issue, which are trading at $90%, and
$50m of 10 year bonds which are trading at $108%.
The risk free rate is 2.5% and the corporation tax rate is 30%.
Required:
Calculate the company's post-tax cost of debt capital.
(Use the information in the table of credit spreads above).
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Chapter 6
More details on the 'risk free rate' – The spot yield curve
In all the previous examples, the risk free rate has been given as a single figure,
based on the return required on government bonds.
However, in reality the return required will usually be higher for longer dated
government bonds, to compensate investors for the additional uncertainty
created by the longer time period.
Therefore, you might be given a 'spot yield curve' for government bonds,
instead of a single 'risk free rate'. Then to calculate the yield curve for an
individual company's bonds, add the given credit spread to the relevant
government bond yield.
Test your understanding 7
The spot yield curve for government bonds is:
Year %
1 3.50
2 3.65
3 3.80
The following table of credit spreads (in basis points) is presented by
Standard and Poor's:
Rating 1 year 2 year 3 year
AAA 14 25 38
AA 29 41 55
A 46 60 76
Required:
Estimate the individual yield curve for Stone Co, an A rated
company.
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The weighted average cost of capital (WACC)
Estimating the spot yield curve
There are several different methods used to estimate a spot yield curve,
and the iterative process based on bootstrapping coupon paying bonds is
perhaps the simplest to understand. Discussion of other methods of
estimating the spot yield curve, such as using multiple regression
techniques and observation of spot rates of zero coupon bonds, is
beyond the scope of the AFM syllabus.
The following example demonstrates how the iterative process works:
Illustration of how to calculate the spot yield curve for government
bonds
A government has three bonds in issue that all have a par value of $100
and are redeemable in one year, two years and three years respectively.
Since the bonds are all government bonds, let’s assume that they are of
the same risk class. Let’s also assume that coupons are payable on an
annual basis.
Bond A, which is redeemable in a year’s time, has a coupon rate of 7%
and is trading at $103.
Bond B, which is redeemable in two years, has a coupon rate of 6% and
is trading at $102.
Bond C, which is redeemable in three years, has a coupon rate of 5%
and is trading at $98.
To determine the spot yield curve, each bond’s cash flows are discounted
in turn to determine the annual spot rates for the three years, as follows:
Bond A: $103 = $107/(1 + r1)
so r1 = 107/103 – 1 = 0.0388 or 3.88%
Bond B: $102 = ($6/1.0388) + [106/(1 + r2)2]
so r2 = [106/(102 – 5.78)]1/2 – 1= 0.0496 or 4.96%
Bond C: $98 = ($5/1.0388) + ($5/1.04962) + [105/(1 + r3)3]
so r3 = [105/(98 – 4.81 – 4.54)]1/3 – 1 = 0.0580 or 5.80%
The annual spot yield curve is therefore
Year %
1 3.88
2 4.96
3 5.80
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Chapter 6
Student Accountant article
The examiner's article 'Bond valuation and bond yields' in the Technical Articles
section of the ACCA website covers the calculation of bond yield curves in more
detail.
Using the CAPM to calculate cost of debt
The CAPM can be used to derive a required return as long as the systematic
risk of an investment is known. Earlier in the chapter we saw how to use an
equity beta to derive a required return on equity. We also said that the risk on
debt is usually relatively low, so the debt beta is often zero. However, if the debt
beta is not zero (for example if the company's credit rating shows that it has a
credit spread greater than zero) the CAPM can also be used to derive kd as
follows:
kd = Rf + ßdebt (E(Rm) – Rf)
Then, the post-tax cost of debt is kd (1–T) as usual.
Test your understanding 8 – WACC
An entity has the following information in its balance sheet (statement of
financial position):
$000
Ordinary shares (50c nominal) 2,500
Debt (8%, redeemable in 5 years) 1,000
The entity's equity beta is 1.25 and its credit rating according to Standard
and Poor's is A. The share price is $1.22 and the debenture price is $110
per $100 nominal.
Extract from Standard and Poor's credit spread tables:
Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr
AAA 5 10 15 22 27 30 55
AA 15 25 30 37 44 50 65
A 40 50 57 65 71 75 90
The risk free rate of interest is 6% and the equity risk premium is 8%. Tax
is payable at 30%.
Required:
Calculate the entity's WACC.
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Chapter 6
4 How do lenders set their interest rates?
Link to credit spreads
The table of credit spreads shown above showed the premium over risk free
rate which a company would have to pay in order to satisfy its lenders. Another
way of looking at the issue of yield on a bond is to look at it from the perspective
of the lender.
Overview of the method
Lenders set their interest rates after assessing the likelihood that the borrower
will default. The basic idea is that the lender will assess the likelihood (using
normal distribution theory) of the firm's cash flows falling to a level which is
lower than the required interest payment in the coming year. If it looks likely that
the firm will have to default, the interest rate will be set at a high level to
compensate the lender for this risk.
Introduction to normal distribution theory
The exam formula sheet contains a normal distribution table. Normal
distributions have several applications in the AFM syllabus.
A normal distribution is often drawn as a 'bell shaped' curve, with its peak
at the mean in the centre, as shown:
The figure from the normal distribution table gives the size of an area
(shaded on the diagram) between the mean and a point z standard
deviations away.
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The weighted average cost of capital (WACC)
Example of a simple normal distribution
The height of adult males is normally distributed with a mean of 175 cm
and a standard deviation of 5cm.
What is the probability of a man being shorter than 168cm?
Solution
168cm is 7cm away from the mean.
This represents 7/5 = 1.40 standard deviations.
From tables, 0.4192 of the normal curve lies between the mean and 1.40
standard deviations.
Hence, the probability of a man being shorter than 168cm is 0.5 – 0.4192
= 0.0808 (approximately 8%).
Illustration of how lenders set their interest rates
Villa Co has $2m of debt, on which it pays annual interest of 6%.
The company's operating cash flow in the coming year is forecast to be
$140,000, and currently the company has $12,000 cash on deposit.
Required:
Given that the annual volatility (standard deviation) of the
company's cash flows (measured over the last 5 years) has been
25%, calculate the probability that Villa Co will default on its interest
payment within the next year (assuming that the company has no
other lines of credit available).
Solution
The key here is that Villa Co will have expected cash of $140,000 +
$12,000 = $152,000, and its interest commitment will be 6% on $2m,
i.e. $120,000.
We need to calculate the probability that the cash available will fall by
$152,000 – $120,000 = $32,000 over the next year.
Assuming that the annual cash flow is normally distributed, a volatility
(standard deviation) of 25% on a cash flow of $140,000 represents a
standard deviation of 0.25 × $140,000 = $35,000.
Thus, our fall of $32,000 represents 32,000/35,000 = 0.91 standard
deviations.
From the normal distribution tables, the area between the mean and 0.91
standard deviations = 0.3186.
Hence, there must be a 0.5 – 0.3186 = 0.1814 chance of the cash flow
being insufficient to meet the interest payment.
i.e. the probability of default is approximately 18%.
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