the current cost of debt for the company. Thus, the market value of $1 billion in debt,
with interest expenses of $60 million and a maturity of 6 years, when the current cost
of debt is 7.5% can be estimated as follows:
(vi) Gross Debt versus Net Debt. Gross debt refers to all debt outstanding in a firm.
Net debt is the difference between gross debt and the cash balance of the firm. For
instance, a firm with $1.25 billion in interest bearing debt outstanding and a cash bal-
ance of $1 billion has a net debt balance of $250 million. The practice of netting cash
against debt is common in both Latin America and Europe, and the debt ratios are
usually estimated using net debt.
It is generally safer to value a firm based on gross debt outstanding and to add the
cash balance outstanding to the value of operating assets to arrive at the firm value. The
interest payment on total debt is then entitled to the tax benefits of debt and we can as-
sess the effect of whether the company invests its cash balances efficiently on value.
In some cases, especially when firms maintain large cash balances as a matter of
routine, analysts prefer to work with net debt ratios. If we choose to use net debt ratios,
we have to be consistent all the way through the valuation. To begin, the beta for the
firm should be estimated using a net debt ratio rather than a gross debt ratio. The cost
of equity that emerges from the beta estimate can be used to estimate a cost of capital,
but the market value weight on debt should be based upon net debt. Once we discount
the cash flows of the firm at the cost of capital, we should not add back cash. Instead,
we should subtract the net debt outstanding to arrive at the estimated value of equity.
Implicitly, when we net cash against debt to arrive at net debt ratios, we are as-
suming that cash and debt have roughly similar risk. While this assumption may not
be outlandish when analyzing highly rated firms, it becomes much shakier when debt
becomes riskier. For instance, the debt in a BB rated firm is much riskier than the
cash balance in the firm and netting out one against the other can provide a mislead-
ing view of the firm’s default risk. In general, using net debt ratios will overstate the
value of riskier firms.
(vii) Estimating the Cost of Capital. Since a firm can raise its money from three
sources—equity, debt, and preferred stock —the cost of capital is defined as the
weighted average of each of these costs. The cost of equity (ke) reflects the riskiness
of the equity investment in the firm, the after-tax cost of debt (kd) is a function of the
default risk of the firm and the cost of preferred stock (kps) is a function of its inter-
mediate standing in terms of risk between debt and equity. The weights on each of
these components should reflect their market value proportions since these propor-
tions best measure how the existing firm is being financed. Thus, if E,D, and PSare
the market values of equity, debt, and preferred stock, respectively, the cost of capi-
tal can be written as follows:
Cost of capitalkeaE
DEPSbkdaD
DEPSbkpsaPS
DEPSbEstimated market value of debt 60 °1 1
1.075^6
0.075¢1,000
1.075^6$ 930 million9 • 30 VALUATION IN EMERGING MARKETS