Why Do We Mess With the Cost of Equity Reviewed by Momizat on . But Not the Cost of Debt? Determining the cost of equity can be quite interesting whereas determining the cost of debt is often boring. We may add items to the But Not the Cost of Debt? Determining the cost of equity can be quite interesting whereas determining the cost of debt is often boring. We may add items to the Rating: 0
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Why Do We Mess With the Cost of Equity

But Not the Cost of Debt?

Determining the cost of equity can be quite interesting whereas determining the cost of debt is often boring. We may add items to the cost of equity—such as a size or company specific risk premium—that arguably are not included in the CAPM methodology used to determine the cost equity. But then we do not add these items to the cost of debt. Do only equity investors care about size and company specific risk premiums? Does not including these items in the cost of debt suggest they should not be included in the cost of equity too? This article addresses these questions.

Why Do We Mess With the Cost of Equity but Not the Cost of Debt?

Determining the cost of equity can be quite interesting whereas determining the cost of debt is often boring. We may add items to the cost of equity—such as a size or company specific risk premium—that arguably are not included in the CAPM methodology used to determine the cost equity. But then we do not add these items to the cost of debt. Do only equity investors care about size and company specific risk premiums? Does not including these items in the cost of debt suggest they should not be included in the cost of equity too? This article addresses these questions.

Cost of Debt is (Mostly) Observable Whereas Cost of Equity is Not Observable

Debt and equity instruments are very different. Plain vanilla debt instruments have a defined stream of contractual payments whereas equity has a residual claim on the company’s assets after its liabilities are repaid. Thus, the cost of debt is—at least superficially—readily observable (yield on contractual payments based on the price of the bond)[1] whereas the cost of equity is not observable (because there is no “official” source for projected equity cash flows).

This difference has practical ramifications. It is hard to mess with the cost of debt because the yields are readily observable. Conversely, it is easy to mess with the cost of equity because it is sort of like the Wild West: almost anything can happen. Thus, we may mess with the cost of equity much more than the cost of debt—at least in part—because it is easier to get away with it.

Should Equity Investors Care More About Size and Company Specific Risk Premiums (or Other Adjustments) than Debt Investors?

The short answer is “yes.” Equity investors sit below debt investors in the waterfall, which means they are more exposed to these types of risks than debt investors. Thus, there is clear logic for focusing more on these issues for the cost of equity than the cost of debt.

Should Equity Investors Care a Lot More than Debt Investors?

The short answer is “it depends.” Debt investors should care more when the amount of debt increases. Thus, equity investors should care a lot more than debt investors when debt is “low” and by a smaller extent when debt is “high.” 

What Insights Can We Make From the Cost of Debt When Leverage is High?

Yields on highly levered debt instruments (when available) provide a test for whether sizable adjustments should be made to the cost of equity for issues such as size or company specific risk. For example, it seems difficult to credibly argue that large premiums should be added to the cost of equity when debt investors do not require them on a sizable percentage of the company’s capital structure. A company with say 70% debt/30% equity and no discernable size or company specific risk premium on its debt (i.e., its yields are like yields on debt issued by other companies without size and company specific issues), probably should not have large size or company specific risk premiums applied to the cost of equity. Conversely, a company that clearly pays a premium on its debt relative to other companies would presumably have to pay an even larger premium on its cost of equity.

One must be aware of the interconnection between cost of debt and cost of equity assessments. The percentage of debt in the capital structure is predicated on the value of equity. The value of equity decreases as the cost of equity increases via adjustments for size or company specific risk. Thus, inclusion of large size and company specific risk premiums can result in the equity being worth very little compared to the amount owed on the debt. This observation matters because there can effectively be two diametrically opposed conclusions: (1) debt investors are exposed to most of the risk yet require little to no premiums whereas (2) equity investors require massive premiums (beyond what is implied by their placement in the capital structure).

Where is the Potential for Inconsistencies Most Common?

The potential for large inconsistencies may be most prevalent when assessing leveraged recapitalizations or leveraged buyouts. These debtors typically take on a lot of debt and do not keep the proceeds. Some of these debtors will subsequently file for bankruptcy, which will trigger future fraudulent transfer or preference lawsuits. A key question is whether these debtors were solvent or insolvent when the transaction occurred.

One way to arrive at an insolvency determination is to include a bunch of premiums to the cost of equity; however, one must be careful because the analysis is not performed in a vacuum. This is not a blank slate because contemporaneous debt investors told us about the promised return on debt principal they were willing to accept. One cannot ignore the contemporaneous views backed by real money in the quest to arrive at a different value, especially when the valuation practitioner’s decisions may be credibly characterized as result driven.

Of course, it is possible that debt investors got their contemporaneous assessments wrong. Perhaps they should not have lent money to the debtor because it was insolvent. But the likely driver of this mistake is an overstatement of the debtor’s projected cash flows, not an understatement of the debtor’s cost of capital. This is so because information asymmetry related to company specific information will likely affect the ability to project the debtor’s future cash flows (much) more than the ability to assess the debtor’s cost of capital.  

Why Don’t We Adjust the Cost of Debt for Expected Cash Flows?

It is generally accepted that the cost of capital is applied to expected cash flows. Nevertheless, we typically do not use this principle with the cost of debt.

Expected cash flows for a debt instrument are lower than the contractual payments. Contractual payments (especially for a plain vanilla bond) typically reflect the highest possible payments. Payments can be lower due to credit risk issues. Thus, expected return on debt instruments should reflect (a) the probability that the debtor will default on its obligations and (b) the expected loss given default.

However, we typically do not make these adjustments to contractual payments when assessing the cost of debt. Instead, we tend to do one of two things: (1) use a yield on investment grade debt (e.g., BBB rated) that is not affected much by this issue or (2) use the observed yield from a ‘junk’ bond that overstates the cost of debt by a larger extent. Using an investment grade debt yield (and capital structure) is frequently a lazy approach given that many companies are structured to be below investment grade by design (i.e., to take advantage of a larger tax shield on debt). The ‘junk’ bond yield clearly overstates the cost of debt because it includes a more meaningful adjustment for converting contractual to expected cash flows that does not belong in a cost of debt that is applied to expected cash flows. Thus, we do not mess with the cost of debt when we probably should mess with it a bit.

Conclusion

The cost of debt can provide an interesting anchor for cost of equity assessments. We should use this anchor when it is available.

The cost of debt also probably deserves more attention that it currently gets. We may understate debt capacity (by assuming the amount of debt is lower than it should be) or overstate the cost of debt (by including the adjustment from contractual to expected payments) if we do not give it the attention that it deserves.

Note that this article contains the author’s opinions, which are not the opinions of the author’s employer.

[1] This article will later explain why this issue is more nuanced than it may appear.


Michael Vitti, CFA, joined Duff & Phelps, a Kroll Business in 2005. Mr. Vitti is a Managing Director in the Morristown, NJ office and is a member of the Expert Services practice. He focuses on issues related to valuation and credit analyses across a variety of contested matters.

Mr. Vitti can be contacted at (973) 775-8250 or by e-mail to michael.vitti@kroll.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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