Reading: WACC for Listed Firms

If we want to compute the WACC for a firm, we also have to estimate its cost of debt. There are various possibilities to do that. The most prominent one is to rely the firm's credit rating. The purpose of credit ratings is to assess whether a debtor will be able to meet its financial obligations, i.e., to pay interest in full and in time, and to repay the full nominal amount at maturity. The higher the firm's credit rating (the higher its credit-worthiness), the lower its probability of default.

Credit ratings are assessed and provided by rating agencies such as Standard & Poor's or Moody's Services.  In the following table we illustrate the ratings of these two rating agencies for long-term debt.[1]

If the firm we are interested in has a credit rating, we can infer its cost of debt from observing the credit spreads of comparable firms with the same credit rating. 

To illustrate, let's assume a firm has a credit rating of A. The risk-free rate of return is 2% and comparable firms with a rating of A offer a credit spread of 1.25%. These numbers imply a cost of debt of 3.25% for our firm:

An often-encountered challenge is that the comparable firms operate in a different country with a different interest rate level. If so, we cannot simply add the credit spread (in foreign currency) to the risk-free rate in the firm's home currency. We discuss the necessary adjustments at the end of this module.