Question

We learned interest rates are different across firms, and it varies with a firm's investment horizons because investors (or lenders) consider borrower's risk. But how do they determine or evaluate the borrower's risk? Could you explain it combined with concepts or principles we have learned? (Hint: think the opportunity cost of capital.

Answer 1

As we know that there is a relationship between Risk & Return but there is a big question mark on the realization of return from a risky investment. To realize returns, credit rating agencies like S&P, Fitch, etc or various other risk profiling organizations, categorize investment/borrowers' risk profiles by giving rating. In the classic case of the Banking sector, Banks charge a higher rate of interest for a shorter period of time than a longer period of time not only based on the borrower's risk profile but also return for a shorter period of time. Second, banks charge a higher interest rate to borrowers having a very risk credit rating than lower risk. This higher rate interest rate is because of Risk Premium charged to borrowers based on their risk profile.

Cost of capital is the minimum rate of return from any investment but the opportunity cost of capital is the return foregone for next investment  having similar risk. Cost of capital can be determined by cost of equity and cost of debt in a portfolio have both investment in equity as well as debt.

Cost of Capital = Cost of Equity + Cost of Debt (1-Tax %)

Cost of Equity is dertermined by CAPM model which includes Risk-Free Rate + Risk premium, while Cost of Debt include a interest rate offered based on the credit risk.To calculate Borrower's risk, we calculate Debt-Burdon Ratio, Debt Coverage ratio etc.

* Debt -Burdon Ratio = Recurring Debt/Gross Income

* Interest Coverage Ratio= EBIT/Interest Expenses