International Finance and Accounting Handbook

financing are generally very different from the cost of equity and the cost of financ-
ing for a firm should reflect their costs as well, in proportion to their use in the fi-
nancing mix. Intuitively, the cost of capitalis the weighted average of the costs of the
different components of financing—including debt, equity and hybrid securities—
used by a firm to fund its financial requirements. In this section, we examine the
process of estimating the cost of financing other than equity and the weights for com-
puting the cost of capital.

(i) Calculating the Cost of Debt. Thecost of debtmeasures the current cost to the
firm of borrowing funds to finance projects. In general terms, it is determined by the
following variables:

• The riskless rate.As the riskless increases, the cost of debt for firms will also in-
  crease.


• The default risk (and associated default spread) of the company.As the default
  risk of a firm increases, the cost of borrowing money will also increase.


• The tax advantage associated with debt.Since interest is tax deductible, the
  after-tax cost of debt is a function of the tax rate. The tax benefit that accrues
  from paying interest makes the after-tax cost of debt lower than the pretax cost.
  Furthermore, this benefit increases as the tax rate increases.

The simplest scenario for estimating the cost of debt occurs when a firm has long
term bonds outstanding that are widely traded. The market price of the bond, in con-
junction with its coupon and maturity can serve to compute a yield that we use as the
cost of debt. Alternatively, for firms that have bonds that are rated, we can estimate
their costs of debt by using their ratings and associated default spreads. Thus, a firm
with a AA rating can be expected to have a cost of debt approximately 0.50% higher
than the treasury bond rate, since this is the spread typically paid by AA rated firms.
What happens when, as is often the case with emerging market companies, when
you have firms that have neither bonds outstanding nor a bond rating. You have two
choices.:

1.Recent borrowing history.Many firms that are not rated still borrow money

from banks and other financial institutions. By looking at the most recent bor-

rowings made by a firm, we can get a sense of the types of default spreads being

charged the firm and use these spreads to come up with a cost of debt.

2.Estimate a synthetic rating.An alternative is to play the role of a ratings agency

and assign a rating to a firm based on its financial ratios; this rating is called a

synthetic rating. To make this assessment, we begin with rated firms and ex-

amine the financial characteristics shared by firms within each ratings class. To

illustrate, Exhibit 9.7 lists the range of interest coverage ratios for small manu-

facturing firms in each S&P ratings class for the United States.

Now consider a small firm that is not rated but has an interest coverage ratio of 6.15.
Based on this ratio, we would assess a “synthetic rating” of A for the firm.
In general, there are two problems we run into when we use this approach to esti-

After-tax cost of debt
Pretax cost of debt 11 tax rate 2

9 • 26 VALUATION IN EMERGING MARKETS