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Read more on estimating market value of debt and a synthetic rating

Market value of debt
Synthetic ratings

a.     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.

b.     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.



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