JAMES P. WESTON: Hi, welcome back to "Finance for Non-Finance Professionals." This week, we're talking about the cost of capital, or what discount rate to use when we're discounting future cash flows. In this lesson, we're going to talk about the cost of debt. And to sort of give us a basis for that, we're going to talk about credit ratings and quality spreads. OK, so what makes debt risky? Well, when I think about a rate of return, any rate of return, that was the risk free rate plus some risk premium. What should the risk premium be when we think about debt, when we think about bonds, or bank loans, lines of credit? Well, the main thing that I'm worried about what debt is the fault, right? Because I'm not going to get extra money if the firm does good. And what I'm really worried about what I lend money, either through bonds, or through bank loans, or through lines of credit-- I'm worried about the firm just not paying back, defaulting on their debt. And I'm worried about default. That is going to earn a risk premium. The other thing I'm worried about is, if the firm defaults, how much can I get back? How much? What's my recovery rate going to be in default? Those two things, default and recovery in default, are what are going to put a risk premium on debt. So will a firm default on its debt? Well, the longer the maturity of the debt, the more worried I am about the firm defaulting. The cash that it has on hand, its capital cushion, the lower that is, the more worried I am about default. How much debt it has overall-- the more indebted the firm is, the more worried I am about default. Is the firm profitable? The more profitability it has, the less worried I am about debt. And what are general economic conditions? Are in a recovery? Are we in an expansion? Are we in a recession? That's going to make me worry, or worry more or less about whether or not the firm is going to default. So those are the main things that go on that make me worry about default when I think about the credit worthiness of a firm. All of those things affect the firm's ability to raise capital. All of those are going to go into the cost of debt. You can imagine a firm that comes in and wants to borrow a whole bunch of money for a long time, that doesn't have any cash. They already have a lot of debt. They're not making any money, and we're in the middle of a recession. A bank is going to want to either not lend the money at all, or charge them a really high interest rate. On the other hand, if it's a big diversified industrial conglomerate, and they want to raise money for the next 60 days. They've got tons of money. They don't have any debt. They're making lots of money. We're in an expansion, and they're doing really well. You almost might give them the money for free. You might charge them 1% or 2%, right? All those things together are going to make the banks or the credit markets more or less willing to lend at any given rate. So all those things really go into that risk premium. Now the other thing we want to worry about is, how much can I recover in the state of default? A lot that's going to depend on physical capital, if there is actual physical assets that I can come and take, like airplanes for example. Airline companies borrow lots and lots of money. But that's, from the bank's perspective, OK because they've got it collateralized with airplanes. And airplanes I can just pick up and move someplace else. If I need to, I can come and grab them and sell them, and move them. Their easy. They're physical, and they're transportable. They're marketable. I can sell them. There's a good market for airplanes. They're transportable. I can pick the airplane up, as opposed to some, like maybe tool and die, a machine that's sort of drilled into the ground and bolted into the factory floor. That might be harder to market and transport, even though it's physical capital. The easier it is to recover that collateral, the safer it is to a bondholder. OK, banks and credit rating agencies do a lot of the work for us. They estimate these default and recovery rates and assign classifications. If any of you have ever tried to get credit on your own, you know that you have a credit score. Credit scores work for firms as well. Firms have credit scores. And larger, sort of public firms have credit ratings. So some of the agencies like S&P, or Moody's, or Fitch give them ratings. It's a lot like being in class. You get a rating of A, B, or C depending on your credit worthiness. Your credit worthiness determines what your likelihood of default, or your likelihood of recovery in the existence of default are. And we can use those credit ratings to assign a cost of debt. That's what's going to give us a risk premium to put on top of the risk free rate to assign a cost of debt. If we just look at some of the data, we can look at average yields on debt. This is from some recent data. And I can see if I had a US Treasury-- US Treasury rates are very low right now. One year rate is around 0.2%, or 20 basis points. The 10 year rate's around 2%. The 20 year rate's around 2.5%. There's that relationship we talked about a few lessons ago. The longer the maturity, the higher the discount rates. If I look at AAA rated debt, the highest, the most credit worthy debt-- those trade at what we call a premium to treasuries. That's what we call the quality spread. One year debt trades about 20 basis points higher than treasuries. For five years, it's about half a percentage point higher. For 10 years, it's almost a full percentage point higher. And for 20 years, it's more than a full percentage point higher, 3.7%. And as I go down in credit quality, to AA, to A, to BBB, to BB-- credit quality is going down. And the yields on that debt, or what I would pay if I issued those debts, are going up. So if I were a firm and I wanted to issue 10 year debt, and I was a BB-- my credit score and my credit rating was around BB, I would expect to pay around 5.7%. So that's what's going to give us, just by looking at the prices of other loans and other bonds that are trading in the market, that's going to give me a ballpark for what I would pay if I wanted to go out and raise debt capital today. OK, to sum up, risky debt has to earn some kind of premium. Because otherwise, why wouldn't I just put money in treasuries. Default and recovery in default are the main source of risk that goes into putting that risk premium on top of treasury rates. And credit scores and credit ratings help us determine how risky that debt is.