Question

The following table presents the credit risk spreads for debt based on ratings agency and interest coverage ratio:

Interest Coverage Ratio	Bonds Rating	Spread (bp)
> 8,5	AAA	20
6,50 - 8,50	AA	50
5,50 - 6,50	A+	80
4,25 - 5,50	A	100
3,00 - 4,25	A-	125
2,50 - 3,00	BBB	150
2,00 - 2,50	BB	200
1,75 - 2,00	B+	250
1,50 - 1,75	B	325
1,25 - 1,50	B-	425
0,80 - 1,25	CCC	500
0,65 - 0,80	CC	600
0,20 - 0,65	C	750
< 0,20	D	1000

It is known the following information about the firms Ita, Taf and Csi:

- Ita has an agency rating of AA;

- Taf generates an operating earnings (EBIT) of 1.000.000€ and pay interest in the amount of 125.000€;

- Csi has an agency rating of BBB and generates an operating earnings (EBIT) of 500.000€ and pay interest in the amount of 120.000€;

Determine for each firm:

a) The credit spread;

b) Debt beta if the market risk Premium is 8%;

c) Cost of debt if the risk free rate is 5% and the corporate tax rate is 30%;

d) Calculate the cost of debt through CAPM and debt beta from part b).

e) Explain the differences between the cost of debt of Csi calculated through rating agency and the interest coverage ratio.

Answer 1

a) The Credit spread:

(i) Ita

This firm has agency rating of AA, so corresponding credit spread= 50 basis points (or 50/100=0.5%)

(ii) Taf

Interest coverage ratio = EBIT/Interest amount = 1000000/125000= 8

This falls into the category of 6.50-8.50, hence credit spread= 50 basis points ( or 0.5%)

(iii) Csi

As per Interest coverage ratio= EBIT/Interest amount= 500000/120000= 4.17

This falls into category of 3.00-4.25, hence credit spread= 125 basis points ( or 125/100=1.25%)

As per agency rating of BBB, credit spread = 150 basis points ( or 150/100=1.5%)

b) Debt Beta

    Debt Beta= Credit spread/Market risk premiumI

Firm	Ita	Taf	Csi
Credit spread(%)	0.5	0.5	1.5
Market risk premium(%)	8	8	8
Debt Beta (credit spread/Market risk premium)	0.0625	0.0625	0.1875

c) Cost of Debt:

Firm	Ita	Taf	Csi
Risk free rate(Rf)	5%	5%	5%
Credit spread (c.s.)	0.5%	0.5%	1.5%
Cost of debt=Kd= (Rf+ c.s.)	5.5%	5.5%	6.5%
corporate tax rate	30%	30%	30%
cost of debt after tax( Kd* (1-Tax))	3.85%	3.85%	4.55%

Note: credit spread according to agency ratings (wherever available) is taken into consideration for caclulations.

d) Cost of Debt using CAPM:

According to CAPM,

Kd= Rf+beta(Rm-Rf)

Where Kd= cost of debt

Rf= Risk free return

Beta= Debt beta( calculated in b part)

Rm-Rf= market risk premium

  

Firm	Ita	Taf	Csi
Rf	5%	5%	5%
Beta	0.0625	0.0625	0.1875
Rm-Rf	8%	8%	8%
cost of debt(kd)	5.5%	5.5%	6.5%
corporate tax	30%	30%	30%
cost of debt after tax (Kd* (1-Tax))	3.85%	3.85%	4.55%

  

Note: credit spread according to agency rating is taken into considetation in the calculations.

Happy Learning!