Prime Numbers: Estimating the cost of sub-investment-grade debt

Estimating the value of a company with sub-investment-grade debt (rated BB or below) can be difficult for finance professionals. Using traditional measures, such as yield to maturity (YTM), as a proxy for expected returns on a company’s debt may skew estimates of value, in part because the probability of default is higher for companies rated BB and below. A better bet when estimating the value of a company with uncharacteristically high debt levels is to compare its financial targets or capital structure with those of its industry peers—which will better reflect the industry’s long-term dynamics.

Take a manufacturing company building a new plant catering to rising demand for its products. The plant will cost $1.5 billion and is expected to generate healthy cash flows within three to five years. The manufacturing company has raised 80 percent debt. Its debt-to-value ratio will be high initially but should improve as the expansion project begins to generate cash flows. In that case, finance professionals can develop their estimates by using the expansion project’s debt-to-value target, if the company has disclosed it, or the industry’s median debt-to-value ratio. If a company is not expected to improve its credit rating or intentionally maintains a debt rating below investment grade, it might be best to use the adjusted-present-value method, which splits financing and nonfinancing cash flows and discounts them separately.

David Kohn is a senior knowledge expert and associate partner in McKinsey’s New York office, where Vartika Gupta is a research science expert. Tim Koller is a partner in the Denver office. Werner Rehm is a partner in the New Jersey office.

For a full discussion of this topic, see Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, seventh edition (Wiley Finance, 2020).

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