Read more on estimating market
value of debt and a synthetic
Market value of debt
How do you
get market value of debt when all or even some of your firm's
debt is bank debt and not publicly traded? How would you compute
an updated cost of debt for an unrated company with bank debt?
The questions are related. After
all, we rely on traded bonds or bond ratings to come up with
an updated cost of debt. To estimate the cost of debt for an
unrated company, we would estimate a synthetic rating based upon
the company's financial ratios. In its simplest form, you can
estimate a synthetic rating for a firm based upon its interest
coverage ratio. By estimating a default spread based upon this
synthetic rating and adding it to the riskfree rate, you can
estimate an updated pre-tax cost of debt for this firm.
While many analysts assume that book
debt is equal to market debt to get over the fact that most debt
is not traded, there is a reasonable approximation that you can
use to estimate market value of debt. Consider the book debt
to be the equivalent of a coupon bond, with the book value of
the debt representing face value, the interest payments comprising
the coupon and the weighted average maturity of the debt representing
the maturity of the bond. Using the pre-tax cost of debt from
the synthetic rating as the interest rate, you can compute the
market value of this bond.
How do you
get a market value of equity for a private business?
You can do it in one of two ways.
One is to use a multiple of earnings or book value, based upon
what publicly traded firms in the business trade at, to get an
estimate of market value of equity. The second is to use the
iterative process, where you use your estimated values of debt
and equity to compute the weights in the cost of capital. The
one thing you should avoid doing is using book value weights.