326  Estimating the Cost of Capital To determine a company’s bond rating, a rating agency like S&P or Moody’s will examine the company’s most recent financial ratios, analyze the compa- ny’s competitive environment, and interview senior management. Corporate bond ratings are freely available to the public and can be downloaded from rating-agency websites. For instance, Costco was rated A+ in September 2019 by S&P and Aa3 by Moody’s. Once you have a rating, convert the rating into a yield to maturity. Exhibit 15.10 presents the difference in yields between U.S. corporate bonds and U.S. Treasury bonds. The difference is referred to as the yield spread. All quotes are presented in basis points (hundredths of 1 percent). Because the duration of Costco’s longest-maturity debt was less than ten years, we use Costco’s rating to determine the cost of debt. To do this, we add the default premium for an A+/Aa3 bond (0.8 percent) to our estimate of the risk-free rate (4.1 percent), discussed in the previous section. This leads to a pretax cost of debt of 4.9 percent. Using the company’s bond ratings to determine the yield to maturity is a good alternative to calculating the yield to maturity directly from bond prices. Never, however, approximate the yield to maturity using a bond’s coupon rate. Coupon rates are set by the company at time of issuance and approxi- mate the yield only if the bond trades near its par value. When valuing a company, you must estimate expected returns relative to today’s comparable investments. Thus, when you measure the cost of debt, estimate what a com- parable investment would earn if bought or sold today. Cost of Below-Investment-Grade Debt In practice, few financial analysts distinguish between expected and promised returns. But for debt below investment grade, rated BB or below, using the yield to maturity as a proxy for the cost of debt can significantly overestimate the cost of debt. To understand the difference between expected returns and yield to matu- rity, consider the following example. You have been asked to value a one-year EXHIBIT 15.10  Yield Spread over U.S. Treasuries by Bond Rating, August 2019 Basis points BBB BB B A AA 74 97 148 326 403 Source: Bloomberg bond portfolio with 10-year maturity. Estimating the After-Tax Cost of Debt  327 zero-coupon bond whose face value is $100. The bond is risky; there is a 25 percent chance the bond will default and you will recover only half the final payment. Finally, the cost of debt (not yield to maturity), estimated using the CAPM, equals 6 percent.26 Based on this information, you estimate the bond’s price by discounting expected cash flows by the cost of debt: Price Cash Flows = ( ) + = ( )( ) + ( )( ) = E kd 1 75 100 25 50 1 06 82 55 . $ . $ . $ . Next, to determine the bond’s yield to maturity, place promised cash flows, rather than expected cash flows, into the numerator. Then solve for the yield to maturity: Price Promised Cash Flows YTM YTM = + = + = 1 100 1 82 55 $ $ . Solving for YTM, the $82.55 price leads to a 21.1 percent yield to maturity— much higher than the 6 percent cost of debt. Why the large difference between the cost of debt and yield to maturity? Three factors drive the yield to maturity: the cost of debt, the probability of default, and the recovery rate after default. When the probability of default is high and the recovery rate is low, the yield to maturity will deviate signifi- cantly from the cost of debt. Thus, for companies with high default risk and low ratings, the yield to maturity is a poor proxy for the cost of debt. When a company is not investment-grade, start by assessing the compa- ny’s financial strategy related to capital structure. If the company has unchar- acteristically high levels of debt relative to its peers, use the company’s stated target or a peer-based capital structure to determine the WACC. Estimate the debt rating your company is likely to generate based on this target capital structure. If the company purposely maintains a debt rating below investment grade, we do not recommend using the weighted average cost of capital to value the company. Instead, use adjusted present value. The APV model discounts projected free cash flow at the company’s industry-based unlevered cost of equity and adds the present value of tax shields. For more on APV valuation, see Chapter 10. Incorporating the Interest Tax Shield To calculate free cash flow (using techniques detailed in Chapters 10 and 11), we compute taxes as if the company were entirely financed by equity. By using all-equity taxes, it is possible to make comparisons across companies and over time, without regard to capital structure. Yet since the tax shield has value, it 26 The CAPM applies to any security, not just equities. In practice, the cost of debt is rarely estimated using the CAPM, because infrequent trading makes estimation of beta impossible.