Class 8 Slides

Cost of Debt
WACC

Recap
We are looking for the Weighted Average
Cost of Capital (WACC)
D
E
WACC
* K d *(1 T)
* Ke
D E
D E
Where:
D = $ amount of debt outstanding (market capitalization)
E = $ amount of equity outstanding (market capitalization)

K e Rf * (EMRP)
K d Rf spread

Cost of Debt
Cost of Debt can theoretically use the
same methodology as the Cost of Equity
Bonds are very unique, what benchmark
should be used?
Where do you find the data for a Beta
calculation when the bonds do not trade?

So, we take the second best choice, which

is to use other estimates of the firms cost
of debt

Yield-to-Maturity
Ideally, we would use the Yield-toMaturity (YTM) for a bond newly issued
by the company
Has the company had any recent bond
issues?
If so, how far in the past?

What is the maturity of the bond?

How does the bond fit into the companys
future capital structure plans?
Does the company roll over 5-year bonds? 10years bonds? 1-year bonds?

YTMs
Alternatively, look for fixed rate long-term
bond yields of previously issued debt
We want current yield, not the coupon rate
Pricing and yield data may be tough to find
When was the last time the bond traded?
Is the last trade far enough in the past that the
yield-to-maturity at the last traded price is no
longer applicable?

Current yields on inactively traded bonds

may not be up-to-date enough

Credit Spreads
A credit spread over Rf can be used, after
deciding:
The duration of the debt (5-year, 10-year, 30year, etc.), use the credit spread over the
corresponding Rf
The credit rating of the company (AAA, AA,
etc.)
Keep in mind that the applicable credit rating is
after the new debt is borrowed

Coupon Rates
Capital IQ provides a summary of the
bonds outstanding
Amount outstanding
Coupon rate

When the bonds were originally issued the

coupon rate would have been the bonds
yield-to-maturity (or at least very close)
Provides a historical perspective of the firms
yield-to-maturity

XOMs Cost of Debt

Lets look at the XOM debt summary
pulled from Capital IQ
Freshly issued bonds from March 2014
Issued YTM and current price
3, 5, and 10-year bonds

XOM is rated AAA by S&P

So what should we use for XOMs Kd?

XOM YTM
Requires good pricing data on outstanding
bonds
Particular strength of Bloomberg
Capital IQ now includes bond pricing

How do XOM bonds compare to current

yields?
Bonds trading above par vs. below par
Implication for current YTM?

Current XOM YTMs

Capital IQ, under Fixed Income, presents
a Securities Summary with some current
pricing and yield information
Capital IQ reports Yield-to-Worst which is the
convention for calculating YTM that produces
the lowest yield
Bonds with embedded options have many potential
maturity dates, YTW uses the maturity date that
produces the lowest yield

XOM YTMs
Maturity
March 15, 2017
March 15, 2019
March 15, 2024

Current Price
$100.05
$100.58
$103.18

Offering YTM
0.92%
1.82%
3.18%

Which YTM should we use?

These are nominal yields what do they say
about future economic output?
Do they relate to XOM or GDP?
What is inflation? (~2% in 2013)

XOM Credit Spreads

Corporate bonds trade at a spread above
government bonds
Risky Corporate Bonds vs. Risk-free
Government Bonds
In bond trading parlance, credit vs. cash
Spreads change over time, and in very, very,
rare instances can be negative
When using credit spreads make sure to
match the maturities

XOM Credit Spreads

XOM is rated AAA by S&P
Spreads for AAA corporate bonds vary by maturity
There may be other factors specific to a company that impacts its
credit spread

Current AAA spread to US Government Bonds is 0.53% (from

BofA Merrill Lynch)
This is for the AAA master class subset and averages across all
maturities with AAA ratings

Current spread for bonds of 7-10 years maturity is 1.31%

This master class subset includes bonds of varying credit rating
(must be investment grade)

Determining the exact credit spread will be a work of

judgment

XOM AAA Credit Spreads

Using the AAA Credit Spread (likely an
underestimate for longer-dated maturities
given the mixing of maturities)
Maturity
90-Day T-Bills
5-year TBonds
10-year TBonds
30-year TBonds

Government
Rate
0.03

AAA Credit
Spread
0.53

1.63

0.53

XOM Kd
0.56
2.16

2.42
2.95
How do these
Kd estimates0.53
compare to
the
0.53
3.86
current YTMs3.33

XOM Maturity Credit Spreads

Using the credit spreads by maturity (likely
an overestimate of XOMs cost of debt)
Maturity
5-year TBonds
5-year TBonds
10-year TBonds
10-year TBonds
30-year TBonds

Government
Rate

Spread By
Maturity

XOM Kd

1.63

0.81

2.44

1.63

1.18

2.81

2.42

1.31

3.73

3.33

1.61

4.94

How do these compare to the current

2.42
1.52
3.94
YTMs?

XOM Coupon Rates

Interest Expense / Total Debt
Easy to find, may be misleading depending on what is
included
XOM has a lot of variable rate bonds with almost zero
% interest rates
Variable rates are difficult to model, think of the variation in
rates since 1934
XOM issues a lot of intra-company debt, focus on the data in
the securities summary

XOM Coupon Rate

Using the data on the XOM Capital Structure
Details tab provides a coupon estimate of 3.42%
This includes intra-company loans at negligible
interest rates

Using the data on the XOM Securities Summary

tab provides a coupon estimate of 3.10%
This is substantially impacted by the recent (low
yield) bond issues
Will this continue into the future? For how long?

Historical Perspective
The level of government interest rates
varies over time
The historical data for Rf shows significant
variance over relatively short periods of time

Credit spreads above government yields

also vary over time
When you are projecting forward, and
considering corporate Kd, do current yields
and spreads properly convey the future?

The 10-Year T-Bond Yield

10-Year Corporate Spreads

Government

% Yield

9
8
7
6
5
4
3
2
1
0

Corporate

Spreads by Credit Rating

AAA
40
35
30
25
% Yield 20
15
10
5
0

AA

BBB

BB

CCC

Spreads by Maturity
1-3yr
9
8
7
6
% Yield

5
4
3
2
1
0

3-5yr

5-7yr

7-10yr

10-15yr

15yr+

Average Spread by Rating

Rating

Average Spread

Current

AAA

0.84

0.53

AA

1.07

0.67

1.42

0.86

BBB

2.10

1.51

BB

3.87

2.81

5.73

3.97

CCC

11.80

7.25

Average Spread by Maturity

Maturity

Average Spread

Current

1-3yr

1.35

0.60

3-5yr

1.49

0.81

5-7yr

1.71

1.18

7-10yr

1.71

1.31

10-15yr

1.70

1.52

15yr+

1.80

1.61

Caveats
Spreads are often presented as large
heterogeneous baskets:
The spreads by maturity include all bonds over BBB in
each maturity category
What is the average rating?

The spreads by rating category include bonds across

all maturities
What is the average maturity?

Keep in mind the difference between your companys

credit rating and Kd maturity vs. the average rating and
maturity used to compute the credit spreads

The Final Piece: Taxes

Which Tax Rate should you use?
Marginal, Average, Effective, other?
Cash taxes paid?

Are tax rates constant over time?

Period of losses?

Averages are nice and reasonable, but

watch for radical ups and downs over
time
Tough to go wrong by using the
statutory rate unless there is a
systematic divergence

WACC Choices are Material

Lets go to the XOM example
Current data versus long-term averages
make a big difference in the WACC
Big differences in the WACC mean big
differences in the valuation, as
represented by the Constant Growth
Perpetuity model

XOM WACC Current Data

Using the Current State of Affairs
Debt (from Securities
Summary)
Equity (Market Capitalization)
Kd (Current YTM)
T (Statutory)
Ke
Rf (Current 10-year T-Bond)
Beta (most recent 1-year)
EMRP
WACC

9,036
437,309
2.59%
35.00%
2.42%
0.86
5%
6.62%

XOM WACC Historical

Using the Average State of Affairs
Debt (from Securities Summary)

9,036

Equity (Market Capitalization)

Kd (Historical YTM)
T (Statutory)
Ke

437,309
7.35%
35.00%

Rf (Average 10-year T-Bond)

6.51%

Beta (most recent 15-years)

0.83

EMRP
WACC

5%
10.56%

XOM Valuation Example

Using a Constant Growth Perpetuity
FCF
Growth Rate
Discount Rate
Valuation

7,362
3.00%
6.62%
203,544

FCF
Growth Rate
Discount Rate
Valuation

7,362
3.00%
10.56%
97,415

XOM WACC Choices

WACC Difference of only 3.94%
Difference in WACC leads to 100%+
difference in valuation
Any guesses as to what the growth rate would
have to be in order for the valuations to be the
same at their respective WACC?
A Terminal Growth rate of -0.87% equalizes the
current valuation to 97,415
A Terminal Growth rate of 6.94% equalizes the
historical valuation to 203,544