Question

hi, can anyone tell me where i am going wrong in the theory. when we use synthetic rating to get the cost of debt we use interest coverage ratio and look for the rating( according to the market cap) and define the default spread for the debt.
what if there are two firms both are large-cap have same interest coverage ration, get same rating and same default spread to be charged but" one firm is a cyclical firm and other is a non-cyclical firm"- cyclical firm would be mor risky which can be seen into their "beta". will there not be any difference btw the cost of debt for both firm.

Answer 1

Theoretically you are going right & Obviously their should a be difference in cost of debt for both firms .
I think you will get the point, but let me rehash why we are going this synthetic rating route for getting cost of debt.
1st we look out for long term straight bond with (no special feature) issued by the co to get the yield to maturity.
if you do not find one , we look out the companies rating to get the default spread to estimate the cost of debt.
If both are not available. we go the synthetic rating route.
Here we try to find out the answer to an question of, what would have been companies Rating if it was Rated?
We try to play the role of rating agencies to get synthetic rating & the reason we use interest coverage ratio is out of the 10-12 input which the credit rating agencies use, Interest coverage ratio seems to have carrying maximum weightage & their is high co-relation across the rating & interest coverage ratio & that’s our implicit rationale of using interest coverage ratio to get the approximation of rating .

But are we considering all the qualitative/quantitative factors which the crediting rating agencies does while rating the company? the answer is NO.
In that case is there a chance that our synthetic rating will be different? Yes.

In practice Credit rating agencies do take into account the cyclical nature of business.
(Go to page 6 first paragraph http://img.en25.com/Web/StandardandPoors/SP_CreditRatingsGuide.pdf ) more reading ( http://www.understandingratings.com )
So in your above example the cyclical firm would have got different rating if it was rated by Credit rating agencies and the default spread would have been higher than that of non-cyclical firm . translating into higher cost of debt for cyclical firm.

I think in your example you are assuming both the companies at the top of the economic cycle because of which cyclical firm is having same Interest coverage ration as the non-cyclical firm.

Now.. Is their a way we can control for the Cyclical nature of business in our synthetic rating approach ?
Yes . Since the firm is Cyclical operating Income would be more Volatile Instead of taking operating income of the current year.
you should take average of last 3 or 5 years so if there are any bad years it will pull the average down and if you apply in your example
the Cyclical firms will fall in different rating bucket possibly lower & will derive lower rating and that will translate into higher default spread
& higher cost of debt.