ratedon thebasisof default risk.Whenthere isno rating
available to estimate the cost of debt, there are two
alternatives:
1.Recentborrowing history.Manyfirmsthatarenot rated
still borrow money from banks and other financial
institutions.Bylookingatthemostrecentborrowingsmade
bya firm,wecangetasenseof thedefault spreadsbeing
chargedthefirmandusethesespreadstocomeupwithacost
of debt.
- Estimate a synthetic rating and default spread. An
alternativeistoplaytheroleofaratingsagencyandassigna
ratingto a firmbased onits financial ratios;this rating is
calledasyntheticrating.Tomakethisassessment,webegin
with rated firms and examine the financial characteristics
shared byfirms withineach ratingsclass. Considera very
simpleversion,wheretheratioofoperatingincometointerest
expense(i.e.,theinterestcoverageratio)iscomputedforeach
rated firm.
45 InTable2.4,welisttherangeofinterestcoverageratios
for small manufacturing firms in each S&P ratings class.
46 We alsoreportthetypical defaultspreads forbondsin
each ratings class in 2004.
47
TABLE 2.4Interest Coverage Ratios and Ratings
Source:Compustat andBondsonline.com.
Interest Coverage RatioRatingTypical Default Spread
> 12.50 AAA 0.35%