CF 4: Corporate cost of capital: debt and equity PDF

💵 CF 4: Corporate cost of capital: debt and equity Date @September 18, 2024 Status Done class 💵 adv corporate finance for management Probability of default and the interest rate: the cost of...

💵 CF 4: Corporate cost of capital: debt and equity Date @September 18, 2024 Status Done class 💵 adv corporate finance for management Probability of default and the interest rate: the cost of debt capital 3 costs of capital: cost of capital of the asset side → Ko o WACC cost of equity capital → Ke cost of debt capital → Kd 👉🏼 why do we have 3? because the risk of these 3 is different → if K = free-risk interest rate + risk the risk changes, the risk premium changes premium and K changes Functions of cost of debt capital: 1. for the bank it is an opportunity cost → the return that the bank should receive from lending the money to the firm is equal to the interest rate applied by the bank to the firm 2. for the firm it is an opportunity cost the NPV of an investment must be = 0 → the return you get must be equal to the return you expect to get Kd = IRR → Interest rate = IRR Goal of the firm = maximize equity → the firm wants a return higher than Kd 1. i > Kd the bank will maximize the value of its investment and get a goodwill for the firm, debt increases, EV remains stable, and equity decreases 2. i = Kd → equilibrium 3. i < Kd CF 4: Corporate cost of capital: debt and equity 1  for the bank, the investment has a negative NPV for the firm debt value decreases, equity increases why would you do that? to incentivize investment in certain areas/industries to increase equity value Probability of default and the interest rate We have shown that a relationship exists between operating cash flow risk and dispersion of possible enterprise values. why is the enterprise value distribution relevant? because it is the main determinant of bankruptcy risk and thus the consequential cost of debt The logic of the credit risk assessment process 💡 Company’s liabilities = rights to the company's assets, which often take the form of options, which can be "priced“, in this way determining the value of the company's financial debt a creditworthiness evaluation model should be consistent with the option evaluation theory If the credit assessment model provides a realistic description of the relationship between the characteristics of the company (its value) and the probability of default on its debts, this will also reflect the credit standing of the company this is only possible if the model is based on market (financial) values and future values, and not on historical (accounting) data Such an approach to credit assessment means using an assessment based on all available information, at a certain point in time, about the company's future if the company being valued is listed, this evaluation has already been performed by the market, and is reflected in the market value of the company if the company is not listed then it is necessary to determine its market value based on future cash flows The market value is based on CF 4: Corporate cost of capital: debt and equity 2  expected future cash flows, which are by definition uncertain → it can give rise to actual cash flows different from those expected we do not assume that this valuation is precise → we just assume that the market estimate is the best and most representative estimate that can be arrived at The most subordinated "right" (the one with the lowest reimbursement priority) is equity if the company's future operating prospects start to look better or worse than before, the market value of the assets will change and the share price will be the first to reflect the change in prospects since, however, the enterprise value at any time is "only one of the possible values", it is possible that the actual development of corporate cash flows leads to an enterprise value of the company that is insufficient to pay interest and repay debts → in this case the conditions of failure occur It is not essential to determine whether the company will have sufficient liquidity to pay the interest and the portion of the debt falling due what is relevant is whether the market value of the company's net assets (EV) is adequate compared to the value of debt If the company's assets have sufficient market value, the company can easily raise the necessary liquidity selling part of its assets if the assets are not easily sellable on the market (or cannot be sold), the company can "sell" them indirectly, through: 1. the issuance of further equity capital or 2. the issuance of more debt. The concept of bankruptcy within the Italian legal system 💡 Bankruptcy: 1. default with respect to "liquidity" → the company is considered bankrupt if, at a given “moment", its level of liquidity does not allow it to pay interest on the debt or repay the capital 2. default at "value" → the company is considered bankrupt when, having to pay interest or repay the capital, the nominal value of financial debt is higher than the enterprise value CF 4: Corporate cost of capital: debt and equity 3  In reality, for failure to occur at a given moment in time, 3 conditions must meet together, in order: 1. the company is obliged to repay the debt, otherwise it has no immediate obligations towards the financiers (contractual condition) 2. the company does not have sufficient liquidity to repay the debt, therefore it "breaks" the agreement with the financiers (liquidity condition) 3. the company does not have the possibility of raising further financing that guarantees the liquidity necessary to repay the debts (value condition) → should a company that at time "t" does not have sufficient liquidity to pay interest or repay capital (or both) be considered in "default", or bankrupt? 1️⃣ Consider a company that has made considerable operating investments with a high Net Present Value which, in the future, should generate value [EV and goodwill] and which is, for this reason, in a temporary liquidity crisis in this situation the company is in the conditions for an increase in future cash flows and EV and a consequent reduction in financial leverage "in value" (the EV grows compared to the nominal debt), thus finding itself in a better situation from a prospective financial point of view ("in value") but in a worse situation in terms of current liquidity in a rational and efficient market, there would always be an investor willing to subscribe additional equity capital or a financier willing to activate additional credit lines to overcome the temporary lack of liquidity 2️⃣ Imagine a company that has subscribed a long-term debt and that liquidates its operating assets, thus virtually canceling its future operating cash flows, but having a large amount of liquidity available to pay the interest before repayment of the principal (or interest and principal over long periods) if the liquidity raised is less than the value of the debt, this company is "already virtually bankrupt", even if it is not currently characterized by financial imbalances or lack of liquidity Why is the value default condition that the enterprise value is less than the total debt (and not only the maturing debt)? The bankruptcy of the company occurs when it does not have sufficient liquidity and does not have sufficient "reserves of value" to be able to raise the liquidity necessary to repay the debts → why, however, is the bankruptcy condition that the enterprise value is lower than the value of the total debt and not the debt to be repaid? CF 4: Corporate cost of capital: debt and equity 4  if we imagine a company that has a total enterprise value (including liquidity) of 800, a debt of 1,000 and a maturing debt of 150 then we can hypothesize two cases: 1. the firm has sufficient liquidity (in its EV) to be able to repay the debt (say, 150). In this case the company does not go bankrupt, because it is able to repay the debt, but it is still "virtually bankrupt" because, after the repayment, the EV will drop to 650 and the debt will be equal to 850 2. the company does not have sufficient liquidity to repay the debt. Selling part of the assets would be impossible (or at least useless if not to delay bankruptcy, because selling part of the assets makes the company more liquid but does not increase its value) → in order to raise sufficient liquidity it should: 1. increase capital or 2. "replace" the debt being repaid However, neither of the two hypotheses is economically rational, in fact: 1. if the shareholders invested further equity, due to the reimbursement priority rules, the additional equity would be used to satisfy the value of the uncovered debts. In this way the debtholders would be (very) satisfied, but the shareholders would instantly lose the capital invested 2. the new debtholder would invest money that he already knows will not be returned (at least in part) to the expected value, as the discounted operating payoffs (800) are not sufficient to cover the value of the debt and therefore the investor , "participating" in the failure, would have a negative NPV; therefore he will not invest Once the probabilistic distribution of the possible enterprise values at debt maturity has been determined, the company defines the level of nominal debt it assumes each value of the debt is associated with a cost of debt capital which, in equilibrium, determines the interest rate to be charged → to evaluate the cost of debt capital it is necessary to identify the loss in the event of default once the probabilistic distribution of enterprise values at debt maturity has been identified, it is possible to determine the expected loss in case of bankruptcy, which is equal to the product between the loss for each EV value below Dnom and its probability, determining the correct cost of debt capital [Kd] CF 4: Corporate cost of capital: debt and equity 5  Determining analytically the cost of debt capital At this point we are ready to determine the cost of debt capital with reference to a loan with a specific maturity, assuming some simplifying hypotheses: 1. that the company has subscribed to a single debt 2. that the loan is of the "bullet" type → full repayment of the principal at maturity, without partial repayments during the life of the loan 3. that the risk-free interest rate remains constant over the life of the loan 4. that the company is always able to pay the interest (possibly by contracting new debt) and that it defaults only because it is unable to repay the capital at the end of the financing period The equilibrium condition of the debt is reduced to the fact that the debt, if repaid, can be refinanced by the same or another bank, and this consideration refers to the condition that the expected enterprise value at the time of repayment is at least equal to the value of the debt the company's probability of default is represented by the probability that the expected enterprise value realized in year "n" is lower than the value of the debt → the company will not be able to refinance the debt and therefore collect the liquidity necessary for the repayment, ending up in conditions of actual default CF 4: Corporate cost of capital: debt and equity 6  👉🏼 E{PayoffD } = D nom ​ D nom ∗ irf 1+irf ​ ​ ​ ​ + D nom ∗ irf (1+irf )2 ​ ​ ​ ​ +…+ D nom ∗ irf (1+irf )n ​ ​ ​ ​ + D nom (1+irf )n = ​ ​ ​ ∑t=1 n ​ D nom ∗ irf (1+irf )t ​ ​ ​ ​ + (1+irf )n = Dnom  ​ ​ ​ ​ If, however, the enterprise value at maturity can take on values lower than the value of the debt to be repaid, then there is a probability of loss with respect to the repayment of the debt and the debt becomes risky it becomes necessary to identify an interest rate that allows the lender to "recover" in advance (at expected value) the expected value of the loss at the time of repayment the objective of finding an equilibrium interest rate is therefore to recover, through the numerator of the discounted flows, the expected loss, while keeping the denominator unchanged (risk free rate) 👉🏼 D nom ∗ i∗ 1+irf ​ ​ ​ + D nom ∗ i∗ (1+irf )2 ​ ​ ​ +…+ D nom ∗ i∗ (1+irf )n ​ ​ ​ + D nom (1+irf )n​ ​ ​ − E{Loss} (1+irf )n = E{PayoffD } = Dnom  ​ ​ ​ ​ 👉🏼 If there is an hypothesis of default: D nom ∗ (irf +π) D nom ∗ (irf +π) 💡 π = the premium (%) in terms of additional + +…+ ​ ​ ​ ​ 1+irf (1+irf )2 interest to compensate ​ ​ ​ ​ D nom ∗ (irf + π) D nom − E{Loss} + = E{PayoffD } = D ​ ​ ​ (1+irf )n ​ ​ (1+irf )n ​ ​ ​ for the expected loss at nom ​ maturity 👉🏼 D nom ∗ π 1+irf D nom ∗ π ​ ​ ​ + D nom ∗ π (1+irf )2 E{Loss} ​ + ​ ​ …+ 👉🏼 π= E{Loss} D nom ​ ​ ∗ irf (1+irf )n −1 where i* = ​ ​ ​ (1+irf )n ​ ​ ​ = (1+irf )n  ​ ​ Kd = irf + π ​ In particular, to interpret the formula obtained we must keep in mind that the mechanism for determining the risk premium linked to a specific loan reflects the following variables: 1. the expected loss at maturity depends on the level of debt compared to the enterprise value of the company at the same date (= on the expected value of equity and the degree of financial leverage), but also on the dispersion of EVs the higher the debt compared to the expected market value of the company's assets, the greater the expected loss and the greater the risk premium CF 4: Corporate cost of capital: debt and equity 7  2. the maturity of the debt is also relevant for two mechanisms which, in reality, have an opposite sign compared to the result a. a longer time period tends to increase the standard deviation of enterprise values as it tends to "cumulate" potential negative effects, thus increasing the risk of the debt and the value of the expected loss b. given the same risk and expected loss, a longer duration of the debt allows the debt holder to recover, through the risk premium (π), a greater value during the period in which the interests are paid and makes the expected loss, at current values, smaller as it is further back in time 3. the risk-free interest rate is a variable that reduces the expected value of the loss and, therefore, all other conditions being equal, the existence of a high risk-free interest rate implies a lower value of the credit risk premium ➡️ Alfa company has requested a loan of €400M lasting 5 years and shows at time 0 an enterprise value of €500M. The risk-free interest rate of the economic system for the same duration is equal to 2%. At the end of the financing, after 5 years, the forecast is that the expected enterprise value will still be equal to €500M, with the following distribution. What is the correct level of the cost of debt capital (Kd)? E{Loss} irf 36.3 2% π= ∗ = ∗ (1.02)5 −1 = 1.74% ​ D nom (1+irf )n −1 400 ​ ​ ​ ​ ​ i* = Kd = irf + π = 2% + 1.74% = 3.74% ​ The costs of bankruptcy and the effect on the cost of debt capital Entering a state of bankruptcy generates a series of costs that lead to a reduction in the enterprise value in the event of liquidation: CF 4: Corporate cost of capital: debt and equity 8  1. additional costs that would not have occurred if the activity had continued or the company had been liquidated "in bonis" 2. the reduction of the economic value of the assets in the transition from an going concern/business continuity to a bankruptcy liquidation state → while in the "going concern" hypothesis the value of the company is represented by the discounted future operating financial flows, in the case of bankruptcy the value is transformed into the "bankruptcy liquidation" value 💡 Bankruptcy liquidation value = the value of the transfer of the 💡 Bankruptcy costs = the difference between the expected enterprise value in the company's assets to clearance operating regime and the liquidation value prices of the assets in the bankruptcy regime Bankruptcy costs: 1. costs to the firm 2. costs to claim-holders direct costs monitoring/control costs experts and liquidation costs (direct and indirect) advisors’ costs pre-bankruptcy costs internal structure costs indirect costs eg. debtors do not pay liabilities capital losses Payoff structure with default probability but What happens if we introduce failure costs? without bankruptcy costs: 1. for any value of EV below the nominal debt, the payoff to lenders becomes: EV - Bankruptcy Costs the distribution of payoffs to shareholders and financiers becomes discontinuous and the part of the CF 4: Corporate cost of capital: debt and equity 9  distribution lower than the value of the debt shifts to the left 2. the expected value of the payoffs to shareholders and financiers is no longer equal to the expected value of the possible enterprise values but is reduced below this level by an amount equal to the expected value of the costs of bankruptcy 3. debt holders adjust the equilibrium interest rate charged, in order to maintain an expected value of the payoff equal to the nominal value of the debt or their investment 4. the loss of expected value of the payoff is passed on to the shareholders, who have to bear the loss of overall payoff in terms of expected value Payoff structure with default probability and What are the effects of the costs of bankruptcy costs: bankruptcy on company's equilibrium? 1. the existence of a probability of bankruptcy determines a risk of (further) loss for the debtholders and this risk must be recognized in terms of the interest rate 2. the costs of bankruptcy in fact determine a higher expected loss and therefore require a higher risk premium and a higher cost of capital 3. the bankruptcy costs are borne financially by the debt holders who require the company to pay higher interest to protect themselves 4. the expected bankruptcy costs are “passed on" to the shareholders, through the risk premium and the cost of debt capital → reduction in the expected payoff to equity = value of the expected failure costs reduction in the total payoff to shareholders and debt holders (the enterprise value levered remains the same but the enterprise value distributed becomes lower) due to the expected bankruptcy costs CF 4: Corporate cost of capital: debt and equity 10  👉🏼 E{Losstot } = E{Loss} + E{BC} ​ 👉🏼 πBC = ​ E{Loss}+E{BC} D nom ​ ​ ∗ irf (1+irf )n −1 → ​ ​ ​ i* = Kd= irf + πBC  ​ ​ Cost of debt capital and financial leverage The graph highlights the dynamics of the cost of debt capital for different levels of financial leverage at market values, in the hypothesis of the presence and absence of bankruptcy costs. the shape of the function is substantially similar (the point of default is, obviously, identical) the slope is different, because the same probability of default implies higher losses for debt holders that must be recovered through higher financial interests The market value of debt The market value of financial debt represents a relevant element: 1. because it defines the value of equity as the difference between the enterprise value and the value to be repaid to debt holders 2. because it determines the measure of financial leverage and therefore it is one of the elements that defines the risk of equity and its cost of capital. Two kinds of debt: 1. bank debt → the value determination is an implicit process 2. debt that is traded on the market → the price determination process is an explicit process that gives rise to a market price we will deal with the case of bonds to establish the relationship between market value and valuation parameters CF 4: Corporate cost of capital: debt and equity 11  💡 Value of a Bond = the present value of the expected cash flows on the bond, discounted at an interest rate appropriate to its degree of risk since the cash flows on a bond are fixed by principle, the value of a bond is inversely related to the interest rate investors demand for that bond, or its cost of capital When considering the interest rate applicable to the valuation of bonds, there are 3 fundamental variables that influence it: the short-term risk-free interest rate (short-term default-free rate) → it "captures" the overall level of interest rates in the economy the "maturity premium" → the difference between longer-term and short-term risk-free interest rates (generally positive) the bond-specific default risk 👉🏼 ​ ​ d N PVbond = Pmkt = ∑t=1 (1+K )tt ​ Coupon ​ ​ ​ + N om Val (1+K d )N  ​ ​ The periodic interest rate Normally the interest rate associated with a loan is determined on an annual basis if the payment of interest occurs with a frequency other than the annual one (half-yearly, quarterly, monthly) then the discounting mechanism must adapt, identifying a discount rate corresponding to the periodicity of interest payments Assuming that the capitalization of the return is semi-annual, then the capitalization over the time horizon of one year would be equal to: Val1 = Val0 * (1 + Kdsem ) * (1 + Kdsem ) = Val0 * (1 + Kdsem )² ​ ​ ​ ​ ​ ​ → since this value must be identical to the capitalized value on the basis of a corresponding annual rate, it must necessarily be: Val1 = Val0 * (1 + Kdsem )² = Val0 * (1 + Kdyear ) ​ ​ ​ ​ ​ 👉🏼 (1+ Kdsem )² = (1 + Kdyear ) → 1+ Kdsem = √(1 + Kd year ) → Kdsem = ​ ​ 2 (1 + Kdyear )-1 ​ ​ ​ ​ ​ 👉🏼 Kdp = -1 ​ 12/p (1 + Kdyear ) CF 4: Corporate cost of capital: debt and equity 12  👉🏼 Pmkt = ∑t=1 (1+k)t t B nom ∗ i ​ n ​ Coupon B nom ∗ i ​ 1 ​ + B nom (1+k)n ​ ​ = 👉🏼 Pmkt = Bnom 1 ​ ​ i ​ 1 ∗ [ ki − ki ∗ (1+k)n + ​ ​ − ∗ (1+k)n ] = Bnom ∗ [ k ∗ (1 − B nom k ​ ​ k ​ (1+k)n ​ + (1+k)n  ​ ​ ​ ​ ​ 1 1 (1+k)n ) + (1+k)n  ​ ​ This formula applies to all coupon periodicities, provided that the coupon rate and the related cost of capital are expressed on the same basis If the bond is traded on the market and a market price is available, it is possible to calculate the bond's IRR, which is the discount rate at which the sum of the present value of the coupons and the discounted nominal value equals the market price → yield to maturity The use of market data to estimate the cost of debt (Introduction to rating): the practical determination of the cost of debt capital for valuation purposes The determination of the probability of bankruptcy and the subsequent cost of debt capital is carried out by banks and financiers through a complex analytical process the most frequently used variable for this purpose is the interest coverage ratio → this ratio indicates to what extent the resources generated by core management activity (EBITDA) are able to cover the payment of financial charges 👉🏼 Interest coverage ratio = EBITDA / Net financial charges The interest coverage ratio is a "long-term" indicator of the financial equilibrium of the company if the company is in a "steady state" condition, and the ratio remains constantly higher than 1, even if the company were not able to repay the nominal value of the debt, it would still be in a position to pay the interest perpetually, configuring the debt as irredeemable and repaying it over an infinite horizon in terms of the present value of the interest paid → the EBITDA/net financial charges ratio is taken as an indicator of the degree of financial equilibrium of the company and, consequently, of the risk associated with the financial debt In brief: high levels of interest coverage ratios (above 2,5) indicate that the financial debt is at low risk interest coverage ratio levels between 2,5 and 1 imply a medium-high risk debt CF 4: Corporate cost of capital: debt and equity 13  interest coverage ratio levels lower than 1 imply a financial debt at very high risk To estimate the cost of a company's debt capital and its probability of bankruptcy it is possible to use the data offered by the market instead of observing the risk of operating cash flows, transforming it into Enterprise Value risk and calculating the probability of default, the market is used to synthetically estimate the company's financing risk 1. the statistical correspondence between: interest coverage rating probability of default risk premium on a large number of companies is observed on the market 2. interest coverage classes are built that fall within a given rating 3. the interest coverage of a company is calculated, and the class membership is attributed, measuring: the rating, a probability of default and a corresponding risk premium (spread) the cost of debt capital is determined as Kd = irf + spread ​ The determinants of kd: a summary The variables that determine the expected loss in the event of default are: 1. the ability to create economic value through operating activity → E{EV} 2. the E{EV}/Dnom ratio which is equivalent to 1+ E{Eq} /Dnom → it is a measure of the degree of capitalization of the company (at market values) and depends on the expected value of EV (the company's ability to create value) the firm's debt level 3. the dispersion of possible EV values 4. the costs of bankruptcy CF 4: Corporate cost of capital: debt and equity 14  The different conditions of debt capital and the effect on the cost: duration, seniority, guarantees The types of debt most frequently found within companies can be categorized according to the following conditions: Duration→ self-liquidating debt(revolving), demand debt, short-term debt, medium/long-term debt Seniority → senior debt, unsecured debt, subordinated debt, “hybrid” financing Guarantees → unsecured debt versus debt backed by: internal mortgage guarantees on company assets or by external signature guarantees (sureties) or collateral Duration Based on the duration of the debt, it is possible to identify some main categories of debt: Self-liquidating credit (revolving) → normally, with self-liquidating credit lines the bank advances a company's commercial credit (for example, advance on invoices), and is reimbursed through collection Credit at sight → credits and debts at sight are considered to be the revoked and availabile by the creditor at any time without notice or with a notice of 24 hours or one working day Short-term debt → debt that will be repaid within the year according to the civil law criterion or within 18 months according to the financial criterion in the balance sheet, all debts payable within the year are classified among short-term financial debts Medium/long-term debt → medium-term loans are defined as those with a duration of more than 18 months and less than 5 years, while long-term loans are those with a duration of more than 5 years Medium/long-term loans are usually subject to periodic forms of amortization and are often backed by real guarantees (pledge or mortgage) as they are considered riskier Long-term debt is “locked” within the company for a longer period if the company obtains negative results and the actual value of the cash flows brings it towards bankruptcy, the “at sight” debt can be revoked, the short-term debt may not be renewed, but the medium-long term debt instead forces the debt holder to wait, exposing him to greater risk because: CF 4: Corporate cost of capital: debt and equity 15  I may have made a mistake in estimating the distribution and have greater variance I can see that the results of the first few years are bad and I am approaching bankruptcy, but I have no power to reduce the debt level or even renegotiate the interest rate Seniority Based on seniority, i.e. priority in repayment, it is possible to identify these categories of debt: Unsecured debt → this is a debt not backed by any particular guarantee Senior debt → debt that, in the event of a company’s default, is paid back in priority over unsecured debts Subordinated debt → it is a debt which, in the event of insolvency of a company, must be repaid subordinately to the others Mezzanine debt → these are loans with a subordination restriction in repayment compared to normal bank debt they have a hybrid nature between pure financing and equity as the remuneration is made up of two parts, the interest rate on the financing and a variable remuneration based on the company's results (equity kicker) which assimilates it to a similar financing to the contribution of the members The effect of the seniority of the debt is, essentially, to "order" the debts with respect to the expected value of the enterprise in this way, the privileged debts, which are repaid before the others, "are associated" with the free risk component of the value, leaving the most risky component to debts with lower seniority subordinated debts (and mezzanine) are those that are "pushed" towards the highest degree of risk and which are consequently characterized by a higher cost of capital Guarantees Based on the guarantees that secure the debt, it is possible to identify some main categories: Unsecured credit → in Italian law, unsecured credit is defined as credit that is not secured by a pledge or mortgage and is not included among privileged credits CF 4: Corporate cost of capital: debt and equity 16  Debt secured by internal guarantees (pledge or mortgage) on company assets → debts secured by internal guarantees enjoy the privilege when the assets owned by the company serving the guarantee are liquidated Debt supported by external signature guarantees (surety) or real guarantees (pledge or mortgage) on assets → debts supported by external guarantees, when they are not repaid up to their reimbursement value, give the right to the mortgagee or pledgee to be satisfied on the assets serving the guarantee of ownership of the external guarantors The effect of internal guarantees is similar to that of seniority the guaranteed debt is satisfied by dedicating some specific assets (securities or real estate) to its repayment the possible liquidation of the assets "orders" the satisfaction of the debts with respect to what is collected, and any difference with the nominal value of is still satisfied as for the other creditors the cost of capital of a guaranteed debt, which is less risky, will be lower Unlike internal guarantees, external guarantees do not “order” the debt with respect to repayment priority, unless they are directed to specific creditors the other creditors are not disadvantaged by the existence of external guarantees, the probability of entering the bankruptcy area remains the same and the debts do not have a real priority compared to other debts in the event of incomplete satisfaction of the debtors, the guarantee intervenes by "integrating" the payment (only of the guaranteed debts), therefore guaranteeing the debt and lowering the risk and cost of capital for guarantors the effect is similar to the unlimited liability of shareholders CF 4: Corporate cost of capital: debt and equity 17