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The Spread to Treasuries A Measure of Default Risk
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All taxable debt that is issued or traded in the United States capital markets is priced at what is called a spread to Treasuries. The spread to Treasuries implies that all corporate debt will have a higher yield (effective interest cost) than yields associated with comparable-matu-
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rity U.S. Treasury Bonds. This spread will change over time depending on economic conditions and the relative default risk associated with the specific debt security. The interest rate, or yield, of all debt is vitally dependent on the risk-free rate associated with U.S. Treasury debt. The 10-year risk-free rate is our starting point for the WACC calculation. The spread to Treasuries is the measure of default risk on a specific company s debt, and it is an input into the FCFF approach and the ValuePro 2002 software. For a large company with little operating risk and low financial leverage (low percentage of debt in the company s market capitalization), the spread to Treasuries might be quite small (0.75 percent to 1.0 percent). For companies with considerable operating risk or high leverage, the spread to Treasuries might be quite large (5.0 percent to 9.0 percent). The best way to determine default risk is to see how a particular company s debt trades in the market and compare it on a spread basis to comparable-maturity Treasury yields. A small number of debt issues are traded on the New York Stock Exchange. Quotes for listed, publicly traded debt are often available on free Web sites, like Yahoo, in their finance sector. In a pinch, you could always resort to a good financial newspaper, like the Wall Street Journal or Investor s Business Daily for debt quotes. Many companies will not have outstanding debt that is listed or traded on an exchange. Their debt securities will trade in the dealer-to-dealer market, and trade data and market quotes may not be available to the general public. Another way to measure default risk and to estimate spreads is to use the default rating systems that are published by the three major credit rating agencies Standard & Poor s Corporation, Moody s Investor Services, and Fitch & Company. These rating services publish ratings for many corporate debt issuers. The highest credit ratings, which are earned by companies with very low default risk, are AAA/Aaa, and the ratings decline from there. A viable way of estimating the yield on debt of a company that does not have actively traded bonds is to examine the cost of outstanding traded debt from a default ratings standpoint for a similar company. Then use that yield as a proxy for the cost of debt of the company that you are valuing.
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The final adjustment to be made to the cost of debt is to take into account the effect of income taxes. Since interest payments (and interest accruals) are tax deductible for the company, an adjustment to the WACC is made to reflect this corporate tax saving. The higher the corporate income tax rate, the greater is the tax savings from issuing debt, and the lower is the after-tax cost of debt. The deductibility of interest payments reduces the cost of debt financing for the corporation. The equation that represents this deductibility is: After-Tax Cost of Debt Pretax Cost of Debt * (1 Corporate Tax Rate)
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For example, if the risk-free rate is 4.25 percent, and ConEd s debt trades at a 1.0 percent spread to Treasuries, and its tax rate is 35 percent, the pretax cost of debt (4.25 percent 1.0 percent) 5.25 percent, and the after-tax cost of ConEd s debt is: ConEd s After-Tax Cost of Debt [5.25% * (1 .35)] 3.41%
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