Page 80 - Bankruptcy and Reorganization Services

8. Number of employees

In addition to presenting the rate of return earned on the portfolio, the Duff & Phelps Report also pro-
vides the risk premium earned for each of the 25 portfolios in excess of the risk-free rate. The risk pre-
miums earned on the various portfolios are determined once the publicly traded entities have been
grouped into one of the 25 portfolios. Combining the applicable risk-free rates with the calculated risk
premiums represents an appropriate and recognized method of developing or assessing the cost of equity
capital, or discount rate, applicable to the valuation of business interests or assets.

Cost of Debt

In its most basic form, the method for determining the cost of debt is to calculate the debt’s effective in-
terest rate. For companies that can take advantage of the tax benefits of debt, this is done by calculating
the after-tax cost of the debt (yield of the debt multiplied by (1 — tax rate)). For companies in bankrupt-
cy, however, the tax benefit of debt may be significantly deferred, and potentially lost, due to the com-
pany’s inability to generate taxable income. For a business that is expected to continue as a going con-
cern, the tax benefit of interest expense is only lost if there are NOLs that expire before they can be uti-
lized. To the extent that interest expense contributes to the creation of the expired NOLs, the tax shield
attributable to that portion of the interest expense will be lost. For a business that is expected to continue
as a going concern, however, the tax benefit of interest expense is generally realized as the NOLs are
utilized once the company returns to profitability. Accordingly, it is generally appropriate to use the af-
ter-tax cost of debt when estimating a company’s cost of capital.

The cost of debt measures the company’s current cost of borrowing given a specific capital structure.
Debt financing includes leases and both short-term and long-term debt. Several factors, both internal and
external to a subject company, influence the cost of debt, which will be discussed later. It is also im-
portant to keep in mind that the cost of debt used in the weighted average cost of capital calculation
(discussed further later) is actually a company’s current market cost of debt and not its existing (histori-
cal) cost of debt. In other words, it is the interest rate that the company would have to pay to borrow ad-
ditional funds given prevailing market conditions. For companies in bankruptcy, their current cost of
debt (borrowing rate) will reflect their financial distress and more than likely be significantly higher than
for comparable companies not in bankruptcy. Therefore, practitioners should consider, where practical,
using the interest rate associated with the company’s current bond rating to arrive at a more accurate es-
timate of debt cost.

The cost of debt for a company in financial distress can fluctuate to reflect the various stages of the
bankruptcy proceedings, especially for companies who are emerging from bankruptcy with the intent of
operating as a going concern. As the financial leverage of the company changes, the cost of debt will
change in concert with the risk of default.

Convertible Debt, Preferred Stock, Convertible Preferred Stock

Debt and equity capital are the most common sources of capital for mature or financially distressed
businesses that are candidates for some type of workout or restructuring. However, some businesses
have other components of capital within their capital structure. Three examples of other capital compo-
nents are convertible debt, preferred stock, and convertible preferred stock. Although a discussion of the
techniques used to assess the cost of capital for convertible debt, preferred stock, and convertible pre-
ferred stock is beyond the scope of this practice aid, analysts can consult other reference materials to de-
velop such calculations and integrate the results into an overall estimate of a company’s cost of capital.

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