Estimating the Cost of Risky Debt

by Ian A. Cooper, London Business School, and Sergei A. Davydenko, University of Toronto*

his article proposes an easily implemented method for estimating the expected return on risky debt, which is an integral part of calculating the weighted average cost of capital (WACC). The WACC is the required return on the operating assets of a rm. It is used in valuation, capital budgeting, goal setting, performance measurement, and regulation. Its value is one of the most important issues in corporate nance. Yet little research attention thus far has focused on estimating one of its key inputsthe cost of debt. Existing methods often overlook a crucial factor for the cost of debtthe possibility of defaultand thus the use of such methods may result in signicant errors in WACC estimates. The WACC cannot be observed directly and therefore must be estimated. The standard estimation method takes a weighted average of the estimated expected returns on debt and equity:

WACC = pD rD (1 T)+ (1 pD) rE,

(1)

where pD is the market-value proportion of the debt of the rm (market leverage), rD is is the required return or cost of debt, T is the tax rate, and rE is the required return or cost of equity. The expected return on equity is: rE = r + E, (2)

where r is the risk-free rate and E is the equity risk premium. The cost of equity is typically estimated using the capital asset pricing model (CAPM), APT, or variants of the dividend growth model. Its estimation has been the subject of controversy.1 Similarly, the appropriate tax rate to use has also been the subject of debate.2 In the remainder of this article, we set the tax rate to zero for simplicity. By contrast, although risky debt has been studied widely,
*We thank Don Chew, James Gentry, Ilya Strebulaev, Mika Vaihekoski, and Fan Yu for their helpful comments. We are grateful to participants at the European Finance Association, European Financial Management Association, Financial Management Association Europe, INQUIRE Europe, and Lancaster University Finance Workshop. 1. See Ivo Welch, Views of Financial Economists on the Equity Premium and on Professional Controversies, Journal of Business, Vol. 73 (2000), pp. 501537; John Graham and Campbell Harvey, The Theory and Practice of Corporate Finance: Evidence from the Field, Journal of Financial Economics, Vol. 60 (2001), pp. 187243. 2. See Ian Cooper and Kjell Nyborg, Valuing the Debt Tax Shield, Journal of Applied Corporate Finance, (Spring 2007), pp. 5059.

there is no model in a form that can be applied easily to estimate the cost of debt for an individual rm. The most common approach is to use the promised yield on the newly issued debt of the rm as an estimate of the cost of debt in the WACC.3 In theory, however, the expected return on debt should reect the promised yield net of any expected default loss, which in turn is a function of the expected probability of default. As Kaplan and Stein pointed out, Because of default risk expected returns [on highly leveraged corporate debt] are undoubtedly lower than the promised returns.4 Thus, at least for a company with a material probability of default, the use of the promised yield could signicantly overstate both the cost of debt and the WACC. In extreme cases, the use of the promised yield as the cost of debt could even result in the estimated cost of debt exceeding the cost of equity. If the promised yield is not used as the cost of debt, an alternative is to assume that the beta of the debt is zero, implying that the debt has a zero risk premium.5 However, this method also dees economic logic, because the debt risk premium must be greater than zero unless the default risk is entirely diversiable by investors, which is unlikely. The expected return on risky debt thus is neither the promised yield nor the riskless interest rate but instead must lie somewhere in between. The problem with obtaining an estimate of this expected return arises because the spread between the promised yields on risky debt and riskless debt (with the same maturity, liquidity, and tax characteristics) consists of two parts. The rst part reects the expected loss from default. The second part is due to the expected return premium, which reects the undiversiable risk of the debt, so that: Promised yield spread = Expected default loss + Expected return premium. (3)

The expected default loss should not be included in the

3. See, for example, Tim Koller, Marc Goedhart, and David Wessels, Valuation (New York: Wiley, 2005). 4. Steven Kaplan and Jeremy Stein, How Risky Is the Debt in Highly Leveraged Transactions? Journal of Financial Economics, Vol. 27 (1990), pp. 215245 (p. 221). 5. Typical examples of this approach appear in Benjamin Esty, Improved Techniques for Valuing Large-Scale Projects, Journal of Project Finance (Spring 1999), pp. 925, and Carliss Baldwin, Technical Note on LBO Valuation (B), Harvard Business School Case note 9-902-005 (2001).

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cost of debt because it is not part of the expected return. The cost of debt therefore is the promised yield, adjusted for expected default losses as follows: Cost of debt = Promised yield Yield equivalent of expected default loss. (4)

the debt is risky, which is also when the problem of estimating expected return is greatest. As Brealey and Myers put it: This is the bad news: There is no easy or tractable way of estimating the [expected] rate of return on most junk debt issues. 6 Alternative Approaches to Estimating the Expected Return on Risky Debt When promised yields do not provide a sufciently accurate approximation for the cost of debt, several other approaches can be used. One possibility is to apply standard asset pricing models like the CAPM to risky debt. To illustrate, one study has reported betas for high-yield debt of approximately 0.30.7 If the market risk premium is 6%, these estimates imply debt risk premia of approximately 180 basis points. However, this approach requires traded debt price series to estimate betas, and such prices are often unavailable. Moreover, applying this method to an individual companys debt requires great care because debt betas naturally decline as debt matures. Finally, it is not clear that the standard CAPM provides the relevant risk premium model. Taking these issues and the questionable precision of market risk premium estimates into account, it is clear that implementing this approach is difcult. A second approach estimates the frequency of defaults and average recovery rates empirically, and then uses those estimates to adjust the promised yield to obtain the expected return. This approach is typically used to study returns on different bond rating classes.8 For example, one study used historical data on recovery rates and rating migrations to split the debt spread into three parts: expected default, taxes, and a risk premium.9 The researchers argued that the risk premium largely could be explained by common risk factors similar to those of equity risk premia. For a typical 10-year BBB industrial bond, they found that 41 (or 34%) basis points of a total spread of 118 bp could be explained by expected default, leaving 77 bp as the yield spread that should be included in the cost of capital. Although it provides interesting guidelines on the cost of debt, this approach based on historical estimates can be used only when there is a long enough history of debt returns for a sufcient number of similar bonds. Because they use no rmspecic information, the reliability of such estimates depends critically on the assumption that similar bonds have the same expected default rate and rate of return. Another disadvantage of this method is that it is based solely on historical data and thus is not forward-looking. As many observers of high-yield debt markets have suggested, historical default frequencies can be very different from future probabilities,
rate Bond Mortality and Performance, Journal of Finance, Vol. 44 (1989), pp. 909 922. 9. Edward Elton, Martin Gruber, Deepak Agrawal, and Christopher Mann, Explaining the Rate Spread on Corporate Bonds, Journal of Finance, Vol. 56 (2001), pp. 247 277.

As noted above, the yield spread in (3) should be measured relative to a riskless bond with the same maturity, liquidity, and tax characteristics. A simple way of measuring this spread is to calculate debt spreads relative to the AAA rate rather than the Treasury rate. Alternatively, the spread due to default risk can be estimated from the credit default swap market if CDS rates are available. The Importance of Accurate Estimation of the Cost of Risky Debt The bias in the WACC resulting from use of the promised yield as the cost of debt depends on the proportion of the yield spread that is an expected return premium. If the entire spread is an expected return premium, it is correct to use the promised yield. But because there must be some chance of default for the debt to be risky, and because some part of the spread must reect the expected default, the true cost of debt lies somewhere between the two extremes of the promised yield and the riskless rate. To demonstrate that the difference between the promised yield and the expected return on debt can have a material impact on valuation, consider a highly leveraged transaction funded with 70% debt, pD = 70%. Suppose further that the riskless real rate is 3%, the risk premium on the equity of the rm is 6%, and the promised real return on the debt is 7%. The conventional WACC calculation would give: Real WACC (1) = 0.7 7% + 0.3 (3% + 6%) = 7.6%. But if half of the debt premium of 4% (7% 3%) is really compensation for the probability of default, the true expected return on the debt is 5%, and the WACC becomes: Real WACC (2) = 0.7 5% + 0.3 (3% + 6%)=6.2%. With a real WACC of 7.6%, the multiplier for a real perpetuity growing at 3% is 22, whereas with a real WACC of 6.2%, it is 31. Thus, the use of the wrong cost of debt estimate can have a material effect on valuation. These errors in the WACC that can arise from using conventional cost of debt estimates are most signicant when
6. Richard Brealey and Stewart Myers, Corporate Finance, 6th ed. (New York: McGraw-Hill, 2006) p. 515. 7. Marshall Blume and Donald Keim, Lower-Grade Bonds: Their Risks and Returns, Financial Analysts Journal, Vol. 43, (July/August 1987), pp. 2633. 8. See the vast related literature, beginning with Edward Altman, Measuring Corpo-

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particularly when future economic and market conditions likely will differ from those in the past.10 Proposed Method: Inferring the Cost of Debt from Other Inputs to the WACC The approach to estimating the cost of debt that we recommend is different. Specically, it uses a risky debt pricing model to impute the expected rate of return on debt from the standard inputs into the WACC. Whereas other studies proposed estimation methods that are similar in spirit, our approach has several distinct advantages when used in cost of capital estimation.11 Some methods rely on the assumption that the debt pricing model can correctly predict the level of yields, although at present no model does. Others provide only the risk-adjusted probability of default, not the true probability. Still others require complicated inputs that are typically not available when estimating the cost of capital. In contrast, our approach uses a procedure that, by construction, is consistent with the observed debt yield of the company for which the cost of capital is being estimated. Our proposed method sidesteps the well-known problem of the inaccuracy of existing debt pricing models (a problem that doesnt trouble us because we are not concerned with debt valuation per se but rather with inferring the proportion of the actual market spread attributable to expected default) while at the same time enabling us to use inputs that are easily observable. Except for equity volatility, all the inputs required for our procedure are standard inputs for the WACC. The method is thus explicitly designed to yield the expected cost of debt for use in the WACC. The risky debt pricing model that we use was proposed by Robert Merton.12 When combined with estimates of expected equity returns, the Merton model enables us to back out the expected distribution of the value of the rms assets implied by the observed market prices of debt and equity. This distribution can then be used to decompose the debt yield spread into compensation for the expected default and the expected return premium. The Cost of Debt Implied by the Merton Model The Merton model is the simplest equilibrium model of the relationship between corporate interest rates and inputs to the WACC. It assumes that the value of the rms productive assets, V, follows geometric Brownian motion: dV/V = dt + dWt, (5)

where is the expected return on the rms assets, is the volatility of assets, and Wt is a standard Wiener process. In the Merton model, the rm has a single class of zero coupon risky debt of maturity T. In addition, the model assumes a constant interest rate and a simple bankruptcy procedure; namely, if at maturity the value of the assets is lower than the liability, the assets are handed over to the bondholders without costs or violation of priority rules. The simplicity of the model has led to difculties in using it to explain the relationship between the absolute level of debt spreads, capital structure, and asset volatility. In the context of this paper however, we are not interested in the absolute level of the spread. Instead, we use the model simply to divide the observed market spread between the portion that represents expected default and the portion that is the expected return premium. If the Merton model reects at least the rst-order effects relevant for splitting the spread on risky debt, it can be used to estimate the expected return, given the promised yield. For this purpose, it has the merit of being a relatively simple equilibrium model.13, 14 Neither the expected return on assets nor the asset volatility can be directly observed. Moreover, in the presence of multiple issues of debt and debt with coupons and call provisions, the value of debt maturity T in the Merton model is not well dened. The idea behind our procedure is to nd the values of , , and T that reconcile the Merton model with observed debt spreads, given the rms capital structure and other characteristics. After nding the implied parameters of the asset distribution, we can compute the expected return on debt, consistent with this distribution and the return on equity. Merton applied the Black-Scholes option pricing formula to value equity as a call option on a rms assets. Mertons formula can be written in a form that expresses the relationship among the rms leverage pD, the maturity of the debt T, the volatility of the assets of the rm , and the promised yield spread s:15 (1 pD ) = N(d1) pD e sT N(d2), (6)

where N() is the cumulative normal distribution function, and: d1 = [ ln pD (s 2 /2)T ]/T d2 = d1 T. (7) (8)

10. See Paul Asquith, David W. Mullins, and Eric D. Wolff, Original Issue High Yield Bonds: Aging Analyses of Defaults, Exchanges, and Calls, Journal of Finance, Vol. 44 (1989), pp. 923952. 11. A comprehensive list of related references appears in Long Chen, Pierre CollinDufresne, and Robert Goldstien, On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle, Working paper, electronic copy available at http://ssrn.com/ abstract=687473 (2006).

12. Robert Merton, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance, Vol. 29 (1974), pp. 449470. 13. A well-known industry application of the Merton (1974) model is used by MKMV to infer the distance to default from observed equity prices. 14. A related approach was applied to obtain equity expected returns in Murillo Campello, Long Chen, and Lu Zhang, Expected Returns, Yield Spreads, and Asset Pricing Tests, Working paper, available electronically at http://papers.ssrn.com/sol3/papers. cfm?abstract_id=491403 (2006).

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Equation (6) includes two unknowns, and T. However, the Merton model also implies that the equity volatility E satises16 E = N(d1)/(1 pD). (9)

Therefore, we have three observable inputspD, s, and E and two unknowns and T. We solve equations (6) and (9) simultaneously to nd values of and T that are consistent with the observed values of s, pD, and E.17 Essentially, we compute as the implied volatility of the rms assets when equity is viewed as a call option on the assets. The parameter T reects not only the actual maturities of different debt issues in complex capital structures but also the presence of distress costs and other complications not included in the Merton model but reected in the observed spreads.18 After determining the values of and T, we can combine them with the estimate of the expected return on equity given by equation (2) to calculate the expected return on assets and debt. Because equity in this model is a call option on the assets and therefore has the same underlying source of risk as the assets, the risk premia on assets and equity E are related: /E =(-r)/( E-r)= /E. Substituting equation (9) for E yields: = E (1 pD)/N(d1). (10) (11)

Now the part of the spread that is due to expected default can be calculated as:19 = (1/T)ln[e (-s)TN(d1 ET /E)/ pD + N (d2 + ET /E)]. (12)

Numerical Examples Table 1 shows the breakdown of the promised yield spread between the expected return premium and the default risk for representative values of pD, s, E , and E. The values of pD and s are similar to those used in a previous study of debt in 12 large leveraged recapitalizations.20 The equity risk premium values are those commonly used, ranging between 5% and 7%. The volatility of equity is set at a typical level, ranging from 30% to 50% per annum. Panel A of Table 1 shows the results for an investmentgrade issuer, which roughly corresponds to A/BBB rated bonds. The rst row shows the base case with a proportion of debt in the capital structure of 30% and equity volatility of 30% per annum. The equity risk premium is 6% per annum, and the debt spread relative to AAA bonds is 100 basis points per annum. The expected default loss is 16 basis points, which is only a small part of the promised yield spread (16%). As a result, the error from using the promised yield as the cost of debt would be low in this case, consistent with evidence from studies of actual defaults on investment-grade bonds, such as those on the Standard & Poors and Moodys Web sites. Panel B shows the results for a high-leverage rm with a proportion of debt at 70%. The volatility of equity is higher, at 50% per annum, and the debt spread is higher, at 400 basis points. These values roughly correspond to bonds rated B. For the base case, less than half of the debt spread is an expected return premium. Although the promised yield spread is four times greater than that in Panel A, the expected default loss is almost 16 times as high. The proportion of the yield spread that represents expected default is 62%. Therefore, the error resulting from using the promised yield on debt as the cost of debt would be substantial for a highly leveraged rm with these parameter values. Sensitivity Analysis The proportion of the spread that reects expected return is not very sensitive to inputs other than E . In particular, equation (12) shows that it does not depend at all on the risk-free interest rate. According to the results in Table 1, it also is relatively insensitive to realistic levels of variation in pD, s, and E . The insensitivity to pD and E is important, because these variables are difcult to estimate precisely. Although it is sensitive to the volatility of equity, second moments of returns such as E can be estimated relatively
starting points. The intersection of the solution curves (T) from equations (6) and (9) then can be used as the starting point for the system of equations. 18. The values of T derived from the system (6) (9) typically are higher than the true debt maturity, a result of the Merton models failure to take into account bankruptcy costs, strategic debt service, and other important aspects relevant for the expected return on debt. 19. Unlike the return on assets and equity, the calculated return on debt is an annualized compounded return rather than an instantaneous return. 20. Kaplan and Stein (1990), cited previously.

This formula gives the annual yield due to expected default losses on the debt. The cost of debt can be obtained by subtracting it from the promised yield: Cost of debt = Promised yield . (13)

In summary, the resulting cost of debt estimate is consistent with the promised yield on the rms debt and inputs to its cost of capital.
15. Detailed derivations can be found in Ian Cooper and Sergei Davydenko, The Cost of Debt, Working paper (2001), available electronically at: http://papers.ssrn.com/sol3/ papers.cfm?abstract_id=254974. 16. In contrast to asset volatility, the short-term equity volatility is easily observable from either option implied volatilities or analysis of historical returns data. 17. The system of equations is well behaved and generally can be solved by applying standard numerical methods. To ensure a starting point for which standard algorithms quickly yield a solution, we can solve equations (6) and (9) separately for for a few xed values of T (or vice versa). This procedure always converges for any reasonable

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Table 1

Promised yield spread and expected return on debt

The table shows the relationship between the promised debt yield and the expected default loss in the Merton model. The inputs are the leverage ratio pD, the promised spread on debt in basis points s, the equity risk premium E, and the volatility of equity E. The outputs are the expected default loss in basis points and the proportion of the promised debt spread due to the expected default /s. NA means that these input values are incompatible with the model. Sensitivity tests are underlined. pD s (b.p.) E (% p.a.) E (% p.a.) (b.p.) /s (%)

Panel A: Investment-grade debt rm 0.3 0.4 0.2 0.3 0.3 0.3 0.3 0.3 0.3 0.7 0.8 0.6 0.7 0.7 0.7 0.7 0.7 0.7 100 100 100 50 150 100 100 100 100 400 400 400 300 500 400 400 400 400 6.0 6.0 6.0 6.0 6.0 5.0 7.0 6.0 6.0 6.0 6.0 6.0 6.0 6.0 5.0 7.0 6.0 6.0 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.2 0.4 Panel B: High-leverage rm 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.4 0.6 16 19 13 9 22 23 11 NA 42 248 252 244 188 307 270 227 173 292 16.4 18.7 13.4 19.0 14.5 23.4 11.1 NA 41.5 61.9 62.9 60.9 62.7 61.3 67.5 56.7 43.3 73.0

accurately. Thus, the proposed procedure has the merit of being sensitive only to a parameter that can be observed relatively accurately.21 Conclusion The cost of equity and the cost of debt are two key inputs into the weighted average cost of capital (WACC). The former has been the subject of extensive debate, but little attention has focused on the latter. Two common ways to estimate the cost of debt use the promised yield or the riskless rate, but both yield biased results, and the errors could be material. Other estimation methods, such as using the CAPM or adjusting the promised yield for the expected frequency of default, are hard to implement or lead to errors because they fail to capture rm-specic information or current market circumstances. This article proposes a practical way to estimate the true cost of debt that sidesteps some of these problems. Using the Merton model of risky debt, the proposed approach splits
21. Some further evidence regarding the robustness of the Merton model appears in Stephen Schaefer and Ilya Strebulaev, Structural Models of Credit Risk Are Useful: Evidence from Hedge Ratios on Corporate Bonds, Working paper, London Business School (2003).

the promised yield spread into one portion due to expected default and another portion that represents an expected return premium. The inputs required are standard inputs to the WACC and the volatility of equity, which are easily observable. The proposed method uses these inputs to impute the parameters of the Merton risky debt model and compute the expected return on debt. Although the Merton model is a stylized version of real debt structures, it should reect rst-order effects that are relevant to the cost of debt, and therefore can be used to estimate the expected return relative to the promised yield. We illustrate the approach by estimating the cost of debt for parameter values typical to a rm with investment-grade debt and another rm with high leverage, or below-investment-grade debt. In the former scenario, most of the promised yield spread is an expected return premium. In contrast, for a highly leveraged rm with low-grade debt, most of the promised yield spread is expected default. The standard approach of using the promised yield as the cost of debt

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therefore may be adequate for companies with high-grade debt, but for rms with lower-rated debt, it is likely to cause a signicant overstatement of the cost of debt and, hence, of the WACC. In these cases, the approach proposed in this paper can be used to adjust the WACC for the probability of default on the companys debt.

ian cooper is a Professor of Finance at London Business School. sergei davydenko is an Assistant Professor of Finance at the University of Torontos Rotman School of Management.

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