Gross Debt versus Net Debt

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 firm's default risk. In general, using net debt ratios will overstate the value of riskier firms.

Illustration 8.15: Difference between market value and book value debt ratios - Boeing in June 2000

In this illustration we contrast the book values of debt and equity with the market values. For debt, we estimate the market value of debt using the book value of debt, the interest expense on the debt, the average maturity of the debt and the pre-tax cost of debt for each firm. For Boeing, the book value of debt is $6,972 million, the interest expense on the debt is $453 million, the average maturity of the debt is 13.76 years and the pre-tax cost of debt is 6.00%. The estimated market value is as follows:

Estimated MV of Boeing Debt = 453

1.061

0.06

6,972

1.061

To this, we need to add the present value of operating leases of $556 million to arrive at a total market value for debt of $7,847 million.

The book value of equity for Boeing was $12,316 million while the market value of equity was $55,197 million. The debt ratios in market value and book value terms are computed.

Market

Book

12316

6972+12316

The market debt ratio is significantly lower than the book debt ratio.

The market debt ratio is significantly lower than the book debt ratio.

wacccalc.xls: This spreadsheet allows you to convert book values of debt into market values.

Estimating the Cost of Capital

Since a firm can raise its money from three sources -- equity, debt and preferred stock -- the cost of capital is defined as the weighted average of each of these costs. The cost of equity (ke) reflects the riskiness of the equity investment in the firm, the after-tax cost of debt (kd) is a function of the default risk of the firm and the cost of preferred stock (kps) is a function of its intermediate standing in terms of risk between debt and equity. The weights on each of these components should reflect their market value proportions since these proportions best measure how the existing firm is being financed. Thus if E, D and PS are the market values of equity, debt and preferred stock, respectively, the cost of capital can be written as follows:

Illustration 8.16: Estimating Cost of Capital - Boeing

Having estimated the costs of debt and equity in earlier illustrations and the market value debt ratio in Illustration 8.15, we can put them together to arrive at a cost of capital for Boeing.

Cost of Equity = 10.28% (from Illustration 8.8) Cost of Debt = 3.90% (from Illustration 8.10) Market Value Debt ratio = 12.45% (from Illustration 8.15) Cost of capital = 10.28% (0.8755) + 3.90% (0.1245) = 9.49%

Illustration 8.17: Estimating Cost of Capital - Embraer in January 2001

To estimate a cost of capital for Embraer, we again draw on the estimates of cost of equity and cost of debt we obtained in prior illustrations. The cost of capital will be estimated using net debt all the way through (for the levered betas, interest coverage ratios and debt ratios) and in U.S. dollars. Cost of equity = 18.86% (from illustration 8.9) After-tax cost of debt = 7.45% (from illustration 8.11) Market Value of Debt = 1,328 million BR Cash and Marketable Securities = 1,105 million BR Market Value of Equity = 9,084 million BR The cost of capital for Embraer is estimated below: Net Debt = 1,328 million - 1,105 million = 223 million

Cost of Capital = 18.86%

V9084+2230 V9084+223y

To convert this into a nominal real cost of capital, we would apply the differential inflation rates (10% in Brazil and 2% in the US)

Cost of Capital NominalBR = (1 + Cost of Capital$)

f Inflation Rate ö

' Brazil

è Inflation Rate US j

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