FINC3015 Semester 1, 2023

Tutorial 8 Questions
1. Discuss what a firm’s cost of debt represents
The cost of debt represents the rate of return required by debtholders. When an entity chooses to lend money
to a company, it assumes financial risk in the case that the firm cannot repay its debt obligations. For that risk,
debtholders require a rate of return commensurate with that risk. Given that default risk is the most important
consideration for lenders, companies with higher perceived default risk will typically have higher costs of debt.

2. What factors affect a firm’s cost of debt?

Three key factors influence a firm’s cost of debt:
• The biggest determinant of a firm’s cost of debt is default risk. As default risk increases, lenders will
charge higher interest rates to compensate for the higher risk they are taking on
• Second, a firm’s cost of debt depends on market interest rates. Remember that the cost of
capital/equity/debt represents the opportunity cost of investing in company X. As such, as interest rates
rise, investors require a higher yield on outstanding debt
• Third is the tax advantage associated with debt. Because interest is tax deductible, the after-tax cost
of debt is a function of the tax rate. This only affects the cost of debt from the company’s perspective,
and does not directly impact the cost of debt demanded by the market

3. What are the two most common forms of debt and how do they differ?
The two most common forms of debt are bonds and loans. Both are forms of debt but have a few core
differences:
Loans are debt obligations in which a specific time limit is set for the repayment of the debt-money, which
includes the interest amount and the principal amount. The principal amount is mostly paid in regular instalments,
however some loans (such as ‘bullet loans’) may not require any principal repayment until maturity. Loans are
typically provided by private banks with either a fixed or variable interest rate.
Bonds are also debt obligations from which companies can raise money. Different to a loan, bonds are typically
raised in public financial markets directly from market participants. Thus, bonds can be sold on bond markets
and are more liquid than bank loans. Interest rates on bonds can either be fixed or variable, or there could be
no interest (like in the case of zero-coupon bonds).
Companies will generally choose whichever mode of debt is most accessible. For example, very large debt
raises may require an Australian company to issue bonds in the US or Europe in order to get sufficient funds at
a competitive interest rate.

4. Within a company’s debt stack, what are the different tranches of debt that typically exist?
[In order of seniority]
Revolving Credit Facilities (‘Revolvers’) are best conceptualised as a corporate credit card, with firms given a
credit line with a maximum limit. The borrower can access any amount up to this limit at any time and does not
have a specific term within which to pay the loan back. However, interest will accrue on any outstanding funds

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borrowed. For the flexibility afforded by revolvers, companies typically pay an upfront fee (on day 1) and a
regular commitment fee (even on undrawn facility). Much like credit cards for consumers, these facilities often
attract high interest rates.
Senior debt is a lower cost of capital security than subordinated debt. However, because of its lower risk
profile for debtholders, it comes with more onerous covenants and limitations. Senior debt’s tenor is typically
between 4 – 8 years and the covenants associated with it generally restrict the company from making further
acquisitions, raising additional debt and make payments to equity holders. They may also require the company
to maintain certain net-debt to earnings ratios. Senior debt is either amortised over the life of the loan or some
amortisation paid via a large bullet repayment at maturity. Senior debt can be either secured or unsecured.
Subordinated debt is a higher cost of capital security than senior debt and is unsecured. As such, a higher
interest rate is charged for the higher risk. This layer of debt is typically necessary when companies are already
highly levered beyond the point at which banks and other senior debt investors are willing to lend.

Source: Topic 8 Lecture Slides

5. How do we generally conceptualise a firm’s cost of debt and what are the two methods by which
it is estimated?
A firm’s cost of debt is best conceptualised as the marginal cost of debt – meaning the rate at which the firm
could go and raise additional debt. This can be estimated using intrinsic and extrinsic methods.

6. Discuss the intrinsic method of computing the cost of debt and its limitations
When banks lend money to a firm, the interest rate is the explicit cost of debt to the firm at the time of
borrowing. However, this stated interest rate will not portray a firm’s marginal cost of debt later in the loan
life. To figure out a firm’s intrinsic cost of debt, it is important that the firm has publicly traded bonds outstanding.

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If a firm has publicly outstanding debt, the yield to maturity (YTM) is assumed to be the company’s current cost
of borrowing. The yield to maturity is the discount rate that discounts all the future cash flows of the debt
obligation to its current price. As such, it is the closest figure to a firm’s intrinsic cost of debt.
Limitations of the intrinsic cost of debt method includes issues generally associated with publicly traded
instruments – mainly that our calculations may be distorted where the bonds trade with low liquidity or face
other mispricing issues. Additionally, where bonds make up a small portion of a company’s publicly traded
debt, or have maturities not matched to the firm’s broader debt portfolio, the intrinsic method may not
accurately reflect the marginal cost of debt.

7. In the absence of publicly traded bonds, how can we estimate a firm’s cost of debt?
Where a company has no publicly traded debt, or we feel it does not accurately reflect a firm’s cost of debt,
we can look to extrinsic methods instead. There are two key extrinsic methods of estimating a firm’s cost of
debt:
First is the comparable companies cost of debt method. This requires the company at hand to have a credit
rating issued by a rating agency (Moody’s, S&P and/or Fitch). Then, you would look at other similarly rated
companies in the market that have publicly traded bonds, compute the median weighted average yield to
maturity across the peer set and use that as a proxy. By considering bonds recently issued by comparable
firm’s we can estimate the cost our firm would likely incur if issuing debt immediately (the marginal cost of
debt).
Second, if the company has a credit rating, you could also figure out the credit spread (on top of the benchmark
rate) associated with that credit rating. For instance, if the company is BB and the credit spread associated with
2.3%, you would add that 2.3% to the benchmark BBSW rate to figure out the company’s implied cost of
borrowing.
Where a company does not have a credit rating, we can instead use a synthetic cost of debt. This entails the
analyst playing the role of the rating agency and assigning a rating to a firm based on its financial profile.
For instance, the Altman z-score, which is used 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 based on historically
defaulted firms. We can then take this synthetic credit rating, find the credit spread associated with that credit
rating, and compute the cost of borrowing.

8. When using credit ratings to assess a firm’s cost of borrowing, what are some problems that
could arise?
Answers could include:
• Rating agencies may disagree with each other in terms of a firm’s creditworthiness. In this case, it is up
to the analyst to determine which rating agency process is more robust in that specific situation.
• Depending on how public bonds are structured and secured, some firms can have different credit ratings
associated with different bonds.
• As was clear in the 2008 financial crisis, rating agencies make mistakes and there is typically a lag
between changes in credit ratings and changes in default risks for different companies

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• There is some debate as to whether a credit rating normalises for factors such as industry risk, or whether
the analyst needs to screen for comparable issuances in the same industry – this may result in a very
small comparables universe.

9. iPhone Ltd’s balance sheet is as follows:

Assets ($m) Liabilities ($m)
$10,000 Debt: $5,000
Equity: $5,000
In addition, the following information is provided:
• iPhone’s bonds are publicly traded. They have a coupon rate of 10%, a weighted average YTM of
12%, and are AA rated. The market value of the bonds is 80% of the face value.
• The firm has 50 million shares outstanding, pays a dividend of $4/share, current share price of $80
and a P/E of 10x.
• Stock has a beta of 1.2 and the risk-free rate is 8%
• Tax rate is 40%
• EMRP = 5.5%

(a) What is the firm’s debt/capital ratio in both book value and market value terms?
Book value of debt/capital: $5000/$10000 = 50%
Market value of debt/capital: $4000/($4000+$4000) = 50%

(b) What is the firm’s cost of capital?

Cost of debt: 12%
Cost of Equity = 8% +1.2*5.5% = 14.6%
Cost of capital = (50%)*(1- 40%)*12% + (50%)*(14.6%) = 10.9%