MattLikesAnalysis Wrote: ------------------------------------------------------- > but thats exactly what i’m arguing. > > if a company has debt and equity, pre-bankruptcy > and the equity is worth squat, following the > conversion from debt to either all equity or > part-equity, part-debt, the debtholders cost of > capital has gone up since it was JUST a > debtholder, but its cost of capital is not as high > as it was for equity, pre-liquidation. > essentially, it represents a WACC for a similar > company in a similar industry with a similar > financial condition. > > for example: > > pre-bankruptcy: > debt k = 8% > equity k = 30% > > post bankruptcy: > debt k for possible new debt (not debtholders that > entered bankruptcy) = 5-6% > equity k (consists entirely of the old > debtholders) = 12-18% > > > after reorganization, the debtholders of the > bankrupt company would assume more risk as its > likely the assets cannot be sold for 100% of debt > obligations. this is at the expense of the old > equityholders. this increased risk is represented > in a higher cost of capital. whether the old > equityholders equal 0%, 1% or 10% of the ‘newly > formed common shares’, the premise remains the > same, debt holders assume more risk. > > the pre-bankruptcy WACC may be one of the best > starting points to establishing the > post-bankruptcy cost of capital for whatever > securities the debtholders receive > post-bankruptcy. we’re not talking interest rates > here, we’re talking cost of capital. the cost of > capital of the organization should stay the same > if you have the same amount of capital especially > considering the cost of capital of debt rises to > essentially eliminate any tax advantage over a > normalized equity cost of capital, > pre-bankruptcy. > > if the old equityholders are dead, it doesn’t > matter whether the debtholders are reorganized to > get 1% equity and 99% debt for their old debt or > whether they get 100% equity and 0% debt, their > cost of capital is the same as they remain the > sole owners of the business in either scenario. > they essentially assume the WACC of an otherwise > healthy business assuming they cleared up any > operating issues (downsizing, etc) during > bankruptcy and there are no new capital sources. I see what you mean and I think I agree for the most part. As I said above, however, it sounds like in this case the borrower is not going through a bankruptcy proceeding but rather trying to restructure its debt to avoid one, in which case the existing equity will not be wiped out and what needs to be determined is a new interest rate/payment schedule/any other revised terms for the existing debt. In that case your theoretical argument for the new debt terms to mirror the previous WACC for the whole company doesn’t apply, although the new debt terms can obviously be whatever the parties agree. As I said above I don’t think there is any magic to the borrower’s proposal and I imagine that the now-notorious “WACC for West Africa” is simply something the borrower has seized on because it arguably has some relevance to the situation and is a rate that the borrower thinks it can live with (or has simply made up because it’s a rate that the borrower thinks it can live with). If I were the lender I would ignore the name the borrower is giving the number, focus on the number itself (in this case 21%) and any other terms the borrower is proposing to change and go from there to determine whether it’s acceptable. Assuming I had the bargaining position to do so of course.
Here is another way to look at the big picture, and this is the last I’ll say on the matter: since the borrower is proposing to restructure the loan, presumably the interest rate it’s proposing is lower than the interest rate it was paying before it defaulted. If a borrower were paying an interest rate HIGHER than the now-notorious “WACC for West Africa” BEFORE it defaulted, why in the world would a lender simpy accept at face value the claim that the now-notorious “WACC for West Africa” was the appropriate interest rate for the loan AFTER the default? The answer is, it shouldn’t.
Didn’t Shakira sing a song about the WACC in Africa?
Morbius Striptease, I checked the Ibbotson wesbite. I believe you have to purchase the whole report. Captain, the loan is not for restructuring. Company is winding down, and is deciding to pay off the loan. So no question of a future equity/debt comes into play. I am just going to try ask my buddy to negotiate with his old borrowing rate they agreed on and start from there. As for the general discussion on liquidation, if you are investing/lending in a business that might have a high risk of shutting down, then wouldn’t the rates you agreed on already be taking into the account that very fact? Thus, a high rate for equity and maybe a high rate for borrowing as well? Why would there be a new application of WACC in this case? Not arguing about what you explained, but trying to understand the logic here. In fact, I would assume that the debtholders/equity holders would have to agree on a lower rate because the company has just re-emerged and shouldn’t be facing the same amount of risk as such. This is what I gathered from reading a little bit on bankruptcies. Lack of choice plays a role here I think.
All the discussion above suggested that the company wanted to restructure the loan; it would have been helpful if you had made clear otherwise earlier in the thread. If the company is being liquidated then the lender should either be paid back its outstanding principal and interest in full, or if there are not enough assets available to satisfy all its creditors, a portion of that amount depending on the lender’s priority/the loan’s position in the capital structure and the applicable laws. This happens in one fell swoop and there is no interest rate relevant to it. The loan terms available to a company at any given time would depend on its particular situation, but do you really think lenders would tend to a consider a company less risky after it’s gone bankrupt than before? Think about it in terms of personal finance and what lenders think of an individual’s credit after a bankruptcy. That is really all I’m going to say on the matter. Good luck.
Captain Windjammer Wrote: ------------------------------------------------------- > Here is another way to look at the big picture, > and this is the last I’ll say on the matter: since > the borrower is proposing to restructure the loan, > presumably the interest rate it’s proposing is > lower than the interest rate it was paying before > it defaulted. If a borrower were paying an > interest rate HIGHER than the now-notorious “WACC > for West Africa” BEFORE it defaulted, why in the > world would a lender simpy accept at face value > the claim that the now-notorious “WACC for West > Africa” was the appropriate interest rate for the > loan AFTER the default? The answer is, it > shouldn’t. if you’re in dire straits, you never get to restructure your debt at a lower interest rate, that’s insane. because the debtholder has all the bargaining power, they demand a higher interest rate by making the concession of extending their maturity. you’re thinking of an effective interest rate on debt, as opposed to the coupon rate, which is what is important here. the original buyer of the debt (at par) doesn’t care that the interest rate on debt the minute before bankruptcy was 1000%, he cares what his effective interest was at cost, say 10%. now that he gets his debt restructured, he’ll ask for 15-25%, lower than the effective rate prior to bankruptcy of 1000% but higher than the original issue yield of 10%. should none of the debt be converted into equity, this 15-20% will be in line with a highly levered comparable and will lie inbetween the cost of equity and cost of debt for a comparable company.
Capt.Windjammer (nice nick btw)…my bad…I thought you were just talking about a general scenario. I didn’t give any indication it was being restructured as well, so not sure how you picked that up. But thanks for all your inputs, really appreciate that. It’s been helpful and educational. Have a good one.