International Finance and Accounting Handbook

mate the synthetic ratings for emerging market firms. The first is that the synthetic rat-
ings may be skewed by differences in interest rates between the emerging market and
the United States. Interest coverage ratios will usually decline as interest rates increase
and it may be far more difficult for a company in an emerging market to achieve the
interest coverage ratios of companies in developed markets. This can be fixed fairly
simply by either modifying the tables developed using U.S. firms or restating the in-
terest expenses (and interest coverage ratios) in dollar terms. The second problem is
the existence of country default risk overhanging the cost of debt of firms in that mar-
ket. Conservative analysts often assume that companies in a country cannot borrow at
a rate lower than the country can borrow at. With this reasoning, the cost of debt for
an emerging market company will include the country default spread for the country.

The counter to this argument is that companies may be safer than the countries that
they operate in and that they bear only a portion or perhaps even none of the country
default spread.

ILLUSTRATION3:ESTIMATING A COST OF DEBT FOR EMBRAER.

As an example, consider Embraer, the Brazilian aerospace company. To estimate
Embraer’s cost of debt, we first estimate a synthetic rating for the firm. Based upon
its operating income of $810 million and interest expenses of $28 million in 2000,
we arrived at an interest coverage ratio of 28.93 and an AAA rating. While the de-

Company default spreadSynthetic rating

Cost of debtEmerging market company
Riskless rateCountry default spread

9.2 ESTIMATING DISCOUNT RATES 9 • 27

Interest Coverage Ratio Rating Spread

>12.5 AAA 0.75%

9.5–12.5 AA 1.00%

7.5–9.5 A+ 1.50%

6–7.5 A 1.80%

4.5–6 A– 2.00%

3.5–4.5 BBB 2.25%

3–3.5 BB 3.50%

2.5–3 B+ 4.75%

2–2.5 B 6.50%

1.5–2 B– 8.00%

1.25–1.5 CCC 10.00%

0.8–1.25 CC 11.50%

0.5–0.8 C 12.70%

<0.5 D 14.00%

aThis table was developed in 1999 and 2000, by listing out

all rated firms, with market capitalization lower than $2 bil-

lion, and their interest coverage ratios, and then sorting firms

based on their bond ratings. The ranges were adjusted to

eliminate outliers and to prevent overlapping ranges.

Exhibit 9.7. Interest Coverage Ratios and Ratings: Low Market Cap Firms.a