Damodaran on Valuation_ Security Analysis for Investment and Corporate Finance ( PDFDrive )

Interest Coverage RatioRatingTypical Default Spread

9.50–12.50 AA 0.50

7.50–9.50 A+ 0.70

6.00–7.50 A 0.85

4.50–6.00 A– 1.00

4.00–4.50 BBB 1.50

3.50–4.00 BB+ 2.00

3.00–3.50 BB 2.50

2.50–3.00 B+ 3.25

2.00–2.50 B 4.00

1.50–2.00 B– 6.00

1.25–1.50 CCC 8.00

0.80–1.25 CC 10.00

0.50–0.80 C 12.00

< 0.50 D 20.00

Now consider a private firmwith $10 million in earnings
beforeinterestandtaxesand$3millionininterestexpenses;
ithasaninterestcoverageratioof3.33.Basedonthisratio,
wewouldassess aso-called syntheticratingof BBforthe
firm and attach a default spread of 2.50 percent to the
risk-free rate to come up with a pretax cost of debt.

Bybasingthesyntheticratingontheinterestcoverageratio
alone, we run the risk of missing the information that is
availableintheotherfinancialratiosusedbyratingsagencies.
Theapproachdescribedbeforecanbeextendedtoincorporate
otherratios.Thefirststepwouldbetodevelopascorebased
onmultipleratios.Forinstance,theAltmanZ-Score,whichis
usedasaproxyfordefaultrisk,isafunctionoffivefinancial