Syllabus B. Advanced Investment Appraisal B3. Impact of financing on investment decisions and APV

B3g. Credit spread 12 / 18

Syllabus B3g)

Assess the organisation’s exposure to credit risk, including:

i) Explain the role of, and the risk assessment models used by the principal rating agencies
ii) Estimate the likely credit spread over risk free
iii) Estimate the organisation’s current cost of debt capital using the appropriate term structure of interest rates and the credit spread.

Credit spread

The credit spread is a measure of the credit risk associated with a company.

Credit spreads are generally calculated by a credit rating agency and presented in a table like the one below.

The credit spread is in basis point, which means for example 5 = 0.05%.

An alternative technique used for deriving cost of debt is based on an awareness of credit spread (sometimes referred to as the "default risk premium"), and the formula:

kd (1–T) = (Risk free rate + Credit spread) (1–T)

The criteria used by credit agencies for establishing a company’s credit rating are the following:

  1. Industry risk

    measures the how the company’s industrial sector reacts to changes in the economy.

    How cyclical the industry is and how large the peaks and troughs are.

  2. Earnings protection

    measures how well the company will be able to maintain or protect its earnings in changing circumstances.

  3. Financial flexibility

    measures how easily the company is able to raise the finance.

  4. Evaluation of the company’s management

    considers how well the managers are managing and planning for the future of the company.