Estimating a synthetic rating and cost of debt

            Some companies choose not to get rated. Many smaller firms and most private businesses fall into this category. While ratings agencies have sprung up in many emerging markets, there are still a number of markets where companies are not rated on the basis of default risk. When there is no rating available to estimate the cost of debt, there are two alternatives:

  1. Recent Borrowing History: Many firms that are not rated still borrow money from banks and other financial institutions. By looking at the most recent borrowings made by a firm, we can get a sense of the types of default spreads being charged the firm and use these spreads to come up with a cost of debt.
  2. Estimate a synthetic rating: An alternative is to play the role of a ratings agency and assign a rating to a firm based upon its financial ratios; this rating is called a synthetic rating. To make this assessment, we begin with rated firms and examine the financial characteristics shared by firms within each ratings class. To illustrate, table 8.5 lists the range of interest coverage ratios for small manufacturing firms in each S&P ratings class[1].

Table 8.5: Interest Coverage Ratios and Ratings: Low Market Cap Firms

Interest Coverage Ratio

Rating

Spread

> 12.5

AAA

0.75%

9.5 Ð 12.5

AA

1.00%

7.5 Ð 9.5

A+

1.50%

6 Ð 7.5

A

1.80%

4.5 - 6

A-

2.00%

3.5 Ð 4.5

BBB

2.25%

3 Ð 3.5

BB

3.50%

2.5 - 3

B+

4.75%

2 Ð 2.5

B

6.50%

1.5 - 2

B-

8.00%

1.25 Ð1.5

CCC

10.00%

0.8 Ð 1.25

CC

11.50%

0.5 Ð 0.8

C

12.70%

< 0.5

D

14.00%

 

Now consider a small firm that is not rated but has an interest coverage ratio of 6.15. Based on this ratio, we would assess a Òsynthetic ratingÓ of A for the firm.

The interest coverage ratios tend to be lower for larger firms, for any given rating. Table 8.6 summarizes these ratios:

Table 8.6: Interest Coverage Ratios and Ratings: High Market Cap Firms

Interest Coverage Ratio

Rating

Spread

> 8.5

AAA

0.75%

6.5-8.5

AA

1.00%

5.5 Ð6.5

A+

1.50%

4.25- 5.5

A

1.80%

3- 4.25

A-

2.00%

2.5-3

BBB

2.25%

2- 2.5

BB

3.50%

1.75-2

B+

4.75%

1.5-1.75

B

6.50%

1.25-1.5

B-

8.00%

0.8-1.25

CCC

10.00%

0.65-0.8

CC

11.50%

0.2-0.65

C

12.70%

<0.2

D

14.00%

 

This approach can be expanded to allow for multiple ratios and qualitative variables, as well. Once a synthetic rating is assessed, it can be used to estimate a default spread which when added to the riskfree rate yields a pre-tax cost of debt for the firm.

 


[1] This table was developed in 1999 and 2000, by listing out all rated firms, with market capitalization lower than $ 2 billion, and their interest coverage ratios, and then sorting firms based upon their bond ratings. The ranges were adjusted to eliminate outliers and to prevent overlapping ranges.