Cost of Debt for a Private Company, Explained

The question

You are valuing a private company. It has no publicly traded debt and no credit rating. How do you estimate the cost of debt for the WACC? Provide a worked example with a reasonable assumption.

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Study explanation

I would use the synthetic credit rating approach. First, forecast the company's EBIT and interest expense to compute the interest coverage ratio (EBIT / interest expense) over the explicit period. For example, if EBIT is $50M and interest expense is $10M, coverage is 5.0x. Mapping 5.0x to a typical rating scale suggests an S&P rating of BBB. Assuming a risk-free rate of 4% and a BBB credit spread of 1.5%, the pre-tax cost of debt is 5.5%.

If there is no current interest expense (zero debt today), I would estimate the interest expense based on the target debt amount and a plausible borrowing rate, then iterate. Alternatively, I could use the yield on similarly rated public peers' debt.

Follow-up pressure:

  • How would you refine the spread if the company is small and has high customer concentration, which might not be captured by the coverage ratio alone?
  • If the coverage ratio falls dramatically in one year, which year's ratio do you use?

DCF timeline

Line itemYear 1Year 2Year 3Year 4Year 5
Free cash flow5054586368
PV of free cash flow4545444342
Terminal value (Year 5 exit)1,001
PV of terminal value621
Implied enterprise value840
Illustrative figures

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