The Impact of Debt on the Cost of Capital: The New IDW Valuation Note

published on 20 February 2024 | reading time approx. 6 minutes

As part of the ongoing changes in business valuation practice, the Institute of Public Auditors in Germany (IDW) published the valuation note “Consideration of the level of indebtedness in the valuation of companies” on 6 September 2023, thus updating the analogous practice note of 12 September 2018. The changes require an even deeper understanding of a company’s debt and its complex impact on enterprise value, and present further practical challenges for business valuators. This article examines the most important aspects of the new IDW valuation guidelines and highlights the most significant implications – and even new complications – in everyday business valuation.

The concept »
Categorization of companies according to debt »
Impact of debt on cost of capital »
Criticism and recommendations »
Conclusion »

The concept

In general, as long as a company’s debt is low or typical for its industry, the weighted cost of capital initially decreases as debt increases. This is because debt has tax advantages.

For highly leveraged and excessively-leveraged companies, the risk profile of the company increases disproportionately as a result of a further increase in debt and has a negative impact on the value of the company. A significantly higher level of debt (compared to the industry) can lead to financial difficulties and a higher risk of insolvency. This in turn can increase the cost of equity, as equity providers demand a higher return for the increased risk.

A general valuation method for all companies – regardless of their level of debt – can lead to distorted valuation results. Compared to net methods (equity value), gross methods (entity or enterprise value) provide a more realistic view of the cost of capital in the context of the overall capital structure. The new IDW Valuation guidelines clarifiy the necessary distinctions when dealing with debt in the context of business valuation.

Categorization of companies according to debt

The IDW Valuation guidelines introduces a systematic categorization of companies to adequately reflect the impact of different levels of leverage on risk profiles and cost of capital. This categorization is based on the level of leverage and the assessment of default risk and aims to identify the appropriate valuation method that takes into account the specific risks and conditions of each company. Accordingly, the IDW Valuation guideline categorizes companies as having normal leverage, low leverage, high leverage, and excessive leverage.

Source: IDW Praxishinweis

Normally indebted companies: For these companies, the usual treatment of debt in the cost of capital applies. It is assumed that these companies will continue indefinitely. Both gross and net methods are appropriate for valuation.
Low indebted companies: Like normal indebted companies, these companies do not face significant default risks. Therefore, the valuation of these companies is similar to the valuation of normal indebted companies.
Highly indebted companies: These companies are exposed to significant default risks. The IDW Valuation Guidance recommends the use of gross methods such as APV (Adjusted Present Value) or WACC (Weighted Average Cost of Capital) for the valuation, as net methods can lead to unjustifiably high equity costs. Gross methods, such as APV, allow for a more explicit and separate consideration of the tax benefit of interest expense and the additional costs of financial distress.

Under the APV method, a company is valued in two steps. In the first step, the cash flows of the hypothetically unleveraged company are discounted at the unleveraged cost of equity. In a second step, the present value of the tax benefit resulting from debt financing is added. This separation can be particularly useful to accurately reflect the risks and benefits associated with high levels of debt. Finally, the value of equity is obtained by subtracting the value of debt.

Excessively indebted companies: For these companies, the valuation assumes that there is no positive going concern value without successful restructuring. Debt-Equity ratio has a significant impact on the cost of capital due to the high risk of default.

Impact of debt on cost of capital

Each category implies different risk profiles, both operational and financial, which have a direct impact on the selection of the valuation method, including the calculation of the cost of capital and the resulting valuation results.

The IDW Valuation Guidance highlights the following implications.

The impact on the beta factor

The beta factor, which measures the covariance of a company’s stock returns relative to the overall market, plays a central role in determining the cost of equity, particularly within the capital asset pricing model. A company’s level of debt is typically included in the calculation of the leveraged beta factor. This adjusted beta factor is critical in assessing the risk associated with the company’s equity and includes both operational and capital structure risks.

In the case of highly leveraged companies, an increased beta factor can lead to a distorted valuation as it reflects financial risk rather than operational risk.

Implications with respect to the risk premiums for FC interest rates and FC cost of capital

In general, any FC rate includes a risk premium that reflects, among other things, the default risk and systematic risk of the company. This risk premium is usually referred to as the credit spread. It is added to the risk-free rate and increases as the systematic risk associated with higher leverage increases.

Implications of the consideration of debt beta

The IDW Valuation Guidance provides for the indirect determination of debt beta (the risk measure of debt) on the basis of available market data. The consideration of debt beta is essential for companies for which the credit spread, calculated as the difference between the cost of debt and the risk-free interest rate, is significant.

In the valuation of companies with low and normal levels of debt, the risk of default is generally negligible. In practice, the calculation of the credit spread can therefore be simplified by using observed interest rates instead of expected interest costs (interest rates – RF).

In the case of highly leveraged companies, however, the default risk is significant, and therefore the expected RF must first be calculated or the RF rates must be adjusted for the default risk. Only then can the credit spread be adequately calculated as the difference between the expected FC cost and the risk-free rate (FC cost – RF).

Consequently, the credit spread is set in relation to the market risk premium (difference between the return on the market portfolio and the risk-free interest rate (RF)).

Focus on direct and indirect insolvency costs

The IDW’s emphasis on direct and indirect insolvency costs is critical. While direct costs are more tangible and often quantifiable, indirect costs can be more damaging in the long run and affect the strategic positioning and operational success of the company.

Indirect insolvency costs relate in particular to the less tangible, but often far-reaching, effects of financial difficulties on operations. These costs are the result of negative stakeholder reactions and behavioral changes due to perceptions of financial instability. These stakeholders include customers, suppliers, lenders, investors and employees.

Customer Trust and Market Position: In times of crisis, customers may lose confidence in a company’s ability to provide its products or services over the long term. This can lead to a decline in customer demand, weakening the company’s market position and ultimately reducing EBITDA.
Suppliers and credit terms: Suppliers could demand more rigorous payment terms or withdraw if they perceive the risk of insolvency to be too high. This can increase production costs, disrupt supply chains and ultimately reducing EBITDA.
Credit costs: A deteriorating perception of creditworthiness can make it more difficult and expensive for a company to raise new capital. Lenders and investors may demand higher interest rates or withdraw funding altogether.

Insolvency costs have a circular effect, as shown in the following figure. Insolvency costs lead to lower earnings, which in turn have a negative impact on the cost of capital.

Source: IDW Praxishinweis

Criticism and recommendations

Application of Peer Group Leverage Ratio to WACC

The IDW Valuation Guide’s approach to valuing operationally sound but excessive-leveraged companies by adjusting their capital structure to a market leverage ratio means

either adjusting the capital structure to the average leverage ratio of the peer group during a reference period and possibly subsequent periods,
or using the weighted average cost of capital (WACC) of the peer group for all periods.

While these approaches have practical advantages, there are several critical issues and potential risks to consider.

The basic assumption is that the capital structures of the peer group companies are appropriate benchmarks. However, this may not be true in all cases. Companies in the same industry may have very different capital structures due to differences in business models, risk profiles, growth opportunities and management strategies. The use of a “standard” capital structure could lead to distorted valuation results.

In addition, the capital structure of a company and its peers can be significantly affected by prevailing market conditions. For example, companies may be more inclined to take on debt in a low interest rate environment, which may not be sustainable in a high interest rate environment. Adjusting capital structures without taking these conditions into account may lead to inappropriate valuation results.

Recommendation:
Valuators need to critically assess the appropriateness of peer group comparisons. A more individualized and dynamic approach, such as scenario and sensitivity analysis, can provide a more accurate and robust valuation.

Default risk vs. credit spread

The IDW valuation note shows an inconsistency in the treatment of default risk, which reveals a conceptual dilemma. On the one hand, default risk is considered to be negligible for companies with low or normal levels of debt, suggesting that it does not play a significant role in interest rates and the cost of debt. On the other hand, by considering a debt beta and thus a credit spread that includes a default risk component, the importance of default risk for companies with low or normal debt is implicitly recognized. The simultaneous use of both approaches without a clear methodological explanation leads to a conceptual inconsistency that can undermine the credibility of the company valuation.

Recommendation:
To avoid this inconsistency, the default risk must always be adjusted both directly in the FC cost and indirectly in the equity cost by taking into account the debt beta. When converting the FC rates, the probability of default and the recovery rate are taken into account to determine the FC costs relevant for valuation. Another approach is to adjust for unsystematic risk in the credit spread when calculating the debt beta. When considering a debt beta, it is important to note that the debt beta, as a measure of leverage risk, must not be higher than the unlevered beta, as a measure of equity risk. If such discrepancies occur, they are due to the failure to adjust for default risk or unsystematic risk. It should be noted that in a company valuation based on consistent assumptions, all valuation methods – APV, WACC, equity value – must lead to the same equity value.

Conclusion

Specific accounting for leverage and credit risk adds complexity to the valuation process. It requires a deep understanding of the company’s capital structure and market conditions. The valuation becomes more sensitive to market conditions, particularly interest rate fluctuations, which can have a significant impact on highly leveraged companies.

The recommendation in the IDW Valuation Guidelines to use gross methods for highly leveraged companies represents a significant change. This approach allows for a clear separation and better understanding of operational risks, capital structure risks and default risks.

Finally, the new IDW Valuation Guidance provides a detailed approach for analyzing the impact of debt on the cost of capital in business valuations. Important information and practical procedures for calculating the cost of capital are clarified and valuable points of reference for an overall view of insolvency risks and the associated costs are highlighted. However, there are also selective simplifications and inconsistencies – some of which are problematic – that present new challenges to the valuator. What certainly does not change for the valuator is that each business valuation is an individual case with its own particularities.