Estimating Borrowing Rates
EXECUTIVE SUMMARY
Pre-tax cost of debt is used in financial reporting in accounting for leases and application of effective interest rate method in accounting for debt. Buildup method can be applied to determine cost of debt with certain modifications as compared to the similar approach used to determine cost of equity. Generally, buildup method for cost of debt has two steps, i.e., determining the risk free rate and borrower specific credit risk premium. Determining cost of debt for a private company can be complex as existing borrowing arrangements (if any) may have unique financial and non-financial debt covenants and many private companies do not have an established credit rating.
Most sources of information about debt yields cover marketable or traded debt instruments, not private debt. The difference in yields between the marketable and non-marketable debt is a discount for lack of marketability (DLOM). Existing DLOM studies and estimates were developed in relation to cost of equity, not cost of debt. Specifically, empirical studies are based on analysis of restricted stock data. Despite notable differences between debt and equity instruments, certain characteristics of a private company, such as lower or no liquidity, less stringent financial reporting requirements apply to debt instruments just as they do to equity. Key inputs used to determine DLOM per Stout DLOM CalculatorTM would likely serve as key inputs and impact DLOM in a similar way when applied to determine debt DLOM, not just equity DLOM. The inputs include 1) the issuing firm’s estimated financial and market risk; (2) the level of stock market volatility prevailing around the transaction date; and (3) the degree of liquidity of the securities. In our opinion, conceptually, DLOM can apply to measurement of private company debt similar to how it applies to measurement of equity. However, it would not be reasonable to assume that specific amounts of DLOM calculated using stock prices would also apply to debt. Although we believe that DLOM determined for shares should not be applied to debt instruments without additional considerations, equity based DLOM can be used as a reasonableness check in assessing valuation results obtained by applying other valuation methods.
Foreign currency risk adjustment to cost of debt can be determined by adjusting U.S. based rate by the difference in projected inflation of the two currencies. Actual inflation data can be used to adjust the U.S. based rate, if it is considered a reasonable estimate of future expected inflation.
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