💬 How to Estimate Cost of Debt for Private Companies?
For “listed” companies, the Cost of Debt (CoD) is more or less accessible. But how do we estimate this number when valuing a private company?
Let’s say a company has a loan at 8% — can we just say its CoD is 8%?
Or imagine the company has issued bonds, and on the secondary market, those bonds trade at a price that implies a promised return (YTM) of 40%. Does that mean the CoD is 40%?
Of course not.
If a bond’s price is so low that it promises an extremely high return, it means the default risk is very high.
🔍 Example:
Suppose the market price of a bond falls such that its Yield to Maturity (YTM) reaches 40%. Meanwhile, the company’s cost of equity is 12%. In this case, the expected default loss must be at least 28%, because it’s impossible for the cost of debt to be higher than the cost of equity under rational expectations.
📉 The logic:
Expected Default Loss (EDL) = Difference between promised return (YTM) and the true economic cost of debt (CoD).
While YTM is the discount rate that equates the promised cash flows to the bond price, the Cost of Debt is the discount rate that equates the expected cash flows (adjusted for default probability and recovery) to the bond price.
🧮 A Theoretical Formula:
There’s a formula that helps estimate the cost of debt more rigorously: SRP=(1−EDL%)×Yield Spread\text{SRP} = (1 – \text{EDL\%}) \times \text{Yield Spread}
Where:
- SRP = Systematic Risk Premium
- EDL% = Expected Default Loss %
(Based on empirical studies — e.g., Elton et al., 2001 — which estimate loss ratios by credit rating) - Yield Spread = Difference between the corporate bond YTM and a risk-free bond of the same maturity
Example:
If a company has an 8% loan, the risk-free rate is 4%, and EDL = 2.4%, then: SRP=4%×(1−0.024)=3.9%\text{SRP} = 4\% \times (1 – 0.024) = 3.9\% CoD=4%+3.9%=7.9%\text{CoD} = 4\% + 3.9\% = 7.9\%
🔄 Alternative Method: CAPM for Debt
Due to the limited availability of reliable EDL statistics, it’s often more practical to use a modified CAPM approach to estimate Cost of Debt:
- Estimate Debt Beta based on the credit rating
(Ratings are available from agencies like Moody’s, S&P, Fitch…) - Replace the Risk-Free Rate with the YTM on AA-rated bonds, since these are considered to have negligible default risk.
- Use Incremental Beta, i.e., the difference between the target debt rating’s beta and the AA bond beta.
- Market Risk Premium (MRP) should be aligned with the equity market used to estimate beta (usually based on S&P 500 data).
✅ Summary Formula:
Cost of Debt=YTM [AA]+(Incremental β×MRP)
🌍 In Georgia’s context:
You’ll also need to incorporate both country risk and currency risk (for GEL) to get a realistic estimate.
📊 Reference Table: Estimated Debt Betas by Rating
| Credit Rating | Estimated Debt Beta |
|---|---|
| 🟢 AAA | 0.00 – 0.05 |
| 🟢 AA | 0.05 – 0.10 |
| 🟢 A | 0.10 – 0.15 |
| 🟡 BBB | 0.15 – 0.25 |
| 🟠 BB | 0.25 – 0.40 |
| 🔴 B | 0.40 – 0.60 |
| 🔴 CCC | 0.60 – 0.80 |
| ⚫ D (Default) | Approaches 1.00 |
📚 Table Source: ChatGPT
📘 Content Source:
Corporate Valuation: Theory, Evidence and Practice
by Mark E. Zmijewski & Robert W. Holthausen (2nd Edition)
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