What is debt?

            The answer to this question may seem obvious since the balance sheet for a firm shows the outstanding liabilities of a firm. There are, however, limitations with using these liabilities as debt in the cost of capital computation. The first is that some of the liabilities on a firmÕs balance sheet, such as accounts payable and supplier credit, are not interest bearing. Consequently, applying an after-tax cost of debt to these items can provide a misleading view of the true cost of capital for a firm. The second is that there are items off the balance sheet that create fixed commitments for the firm and provide the same tax deductions that interest payments on debt do. The most prominent of these off-balance sheet items are operating leases. In chapter 3, we contrasted operating and capital leases and noted that operating leases are treated as operating expenses rather than financing expenses. Consider, though, what an operating lease involves. A retail firms leases a store space for 12 years and enters into a lease agreement with the owner of the space agreeing to pay a fixed amount each year for that period. We do not see much difference between this commitment and borrowing money from a bank and agreeing to pay off the bank loan over 12 years in equal annual installments.

            There are therefore two adjustments we will make when we estimate how much debt a firm has outstanding.

In practice, analysts use both gross debt and net debt to compute debt ratios.             Gross debt refers to all debt outstanding in a firm. Net debt is the difference between gross debt and the cash balance of the firm. For instance, a firm with $1.25 billion in interest bearing debt outstanding and a cash balance of $1 billion has a net debt balance of $250 million. The practice of netting cash against debt is common in both Latin America and Europe and the debt ratios are usually estimated using net debt.

            It is generally safer to value a firm based upon gross debt outstanding and to add the cash balance outstanding to the value of operating assets to arrive at the firm value. The interest payment on total debt is then entitled to the tax benefits of debt and we can assess the effect of whether the company invests its cash balances efficiently on value.

            In some cases, especially when firms maintain large cash balances as a matter of routine, analysts prefer to work with net debt ratios. If we choose to use net debt ratios, we have to be consistent all the way through the valuation. To begin, the beta for the firm should be estimated using a net debt ratio rather than a gross debt ratio. The cost of equity that emerges from the beta estimate can be used to estimate a cost of capital, but the market value weight on debt should be based upon net debt. Once we discount the cash flows of the firm at the cost of capital, we should not add back cash. Instead, we should subtract the net debt outstanding to arrive at the estimated value of equity.

            Implicitly, when we net cash against debt to arrive at net debt ratios, we are assuming that cash and debt have roughly similar risk. While this assumption may not be outlandish when analyzing highly rated firms, it becomes much shakier when debt becomes riskier. For instance, the debt in a BB rated firm is much riskier than the cash balance in the firm and netting out one against the other can provide a misleading view of the firmÕs default risk. In general, using net debt ratios will overstate the value of riskier firms.