With the Environmental Protection Agency’s proposed greenhouse gas (GHG) emissions standards expected in June 2014, many states are considering their own approaches to provide flexibility in...
Volatile markets call for alternative financial models.
is used, as these companies have scant payout history and the retained earnings are either used to finance growth opportunities or used for stock buyback to enhance shareholder value. The methodology also uses a two-stage model for the merchants. As the earnings of these merchant companies are highly cyclical, the net income is normalized by taking an average over the last five years. Also it’s important to consider the historical growth in addition to the analysts’ consensus earnings forecast as analysts typically ignore cyclicality, which means that these forecasts typically show an upward sloping trend, regardless of whether the companies were at the peak or trough of the cycle.
Just like the cost of equity, the cost of debt is a forward-looking concept, in that it takes the future prospects of the firm into account. Yet, unlike the cost of equity, the expected return on debt can be directly observed in the market. The current yield to maturity (or yield) on the applicable debt best approximates the cost of debt. The cost of debt is the expected return on the bond issued by the security, and tends to be the same as the yield to maturity (also called the promised return) for investment-grade bonds. But for high-yield bonds, because of default risk, the expected returns on high-yield bonds (or highly leveraged debt) undoubtedly are lower than the promised returns. Thus, for a power company (whether utility or merchant) with a significant probability of default, the use of the promised yield could significantly overstate both the cost of debt and the WACC. In extreme cases, the use of the promised yield as the cost of debt even could result in the estimated cost of debt exceeding the cost of equity. This unusual situation is very nearly the case given the current state of the financial markets and its impact on the cost of debt for some firms.
Hence for highly-leveraged bonds, a correction needs to be made to the observed yields to determine the expected return on debt. One possibility is to apply standard asset pricing models like the CAPM to risky debt through estimation of a debt beta. Studies have reported debt betas in the range of 0.3 to 0.5. With a historical market-risk premium of 6.5 percent, 4 the risk premium (or default component) could be in the range of 195 bps to 325 bps. But there are several issues, such as debt maturity, debt retirements and re-financings that complicate this calculation and affect the availability of a consistent price series to estimate a debt beta from a bond price series.
As an alternative to these approaches, an approach based on the “Merton model” 5 has been adopted. This approach strips the default loss component from the promised yield to maturity. This is superior to the other approaches because by doing so, one need not rely on a consistent debt-price series that might not be readily available. For example, in the current market environment, the current yield to maturities for B-rated debt is in the vicinity of 12 percent. However, as