Aswath Damodaran 330
Bond Ratings, Cost of Debt and Debt Ratios
Debt
Ratio Debt
Interest
expense
Interest
Coverage
Ratio
Bond
Rating
Interest
rate on
debt
Tax
Rate
Cost of
Debt
(after-tax)
0 % $ 0 $ 0! AAA 4. 35 % 37. 30 % 2. 73 %
10 % $ 6 , 977 $ 303 9. 24 AAA 4. 35 % 37. 30 % 2. 73 %
20 % $ 13 , 954 $ 698 4. 02 A- 5. 00 % 37. 30 % 3. 14 %
30 % $ 20 , 931 $ 1 , 256 2. 23 BB+ 6. 00 % 37. 30 % 3. 76 %
40 % $ 27 , 908 $ 3 , 349 0. 84 CCC 12. 00 % 31. 24 % 8. 25 %
50 % $ 34 , 885 $ 5 , 582 0. 50 C 16. 00 % 18. 75 % 13. 00 %
60 % $ 41 , 861 $ 6 , 698 0. 42 C 16. 00 % 15. 62 % 13. 50 %
70 % $ 48 , 838 $ 7 , 814 0. 36 C 16. 00 % 13. 39 % 13. 86 %
80 % $ 55 , 815 $ 8 , 930 0. 31 C 16. 00 % 11. 72 % 14. 13 %
90 % $ 62 , 792 $ 10 , 047 0. 28 C 16. 00 % 10. 41 % 14. 33 %
This is the completed schedule of interest coverage ratios, ratings and costs of
debt at different debt ratios ranging up to 90%.
It is significant that EBITDA not change as the debt ratio goes up. The reason
is that the new debt is not used to make the firm larger by taking new projects,
but to buy back equity. (This isolates the effect of the financing decision on the
value of the firm)
We are being simplistic in assuming that the interest coverage ratio solely
determines the ratings. We could use more than one ratio, create a consolidated
score (like the Altman Z score) and make the rating a function of this score.
Note that the effective tax rate increases after the 40 % debt ratio. That is because
we have insufficient income to cover the entire interest expense beyond that
point. (EBIT < Interest Expenses) We therefore lose some of the tax advantage
of borrowing.
