Re: Cost of equity
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Okay, I can agree with that. But does that means that's the rate you should be using to value the company?
If it is then every company you value will be excactly fairly valued because you're taking the market price as a given. I'm not saying that's not the current market cost of equity, so I guess we agree. However, that is not necessarily the rate you should discount future cash flows at. I think you have to agree with that, right?
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Ok, so now we're back at the distinction between:
1) The cost of equity that the firm faces: that will change with the market price of the firm's stock. When the firm's stock price goes down (assuming consistent expected future cash flows), the firm's cost of equity goes up.
2) The cost of equity that you, the investor, would use to value the firm to determine if you believe it's over or undervalued.
At this point, frankly, I'll just stop and say what I do. If I'm trying to value a firm, I estimate future cash flows and calculate the discount rate that equates those future cash flows to the current stock price. If that rate is satisfactory to me, then I may invest. So, for example, I might think that DLTR's future cash flows appear to be discounted at somewhere between 15-20%. That's an acceptable return for me, so I might be DLTR. (I do, in fact, own DLTR.) If that wasn't an acceptable way of doing it, then you could use a beta calculation to estimate the cost of equity you think is appropriate. I agree that using the implied cost of equity to value the firm would be circular - you'd always get the current market price.
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I don't understand your Salton example at all. You state that "During this time [of huge writedowns and bad performance] their market quoted cost of debt remained the same", but then you also say "Here's the twist, they lose a bunch of money, default on their debt, but their cost of debt doesn't move up at all. Why? Because the debt holders really had no leverage to do anything to the company. Management was already getting fired, there were new and promising products comign to market, and it looked like things could turn around. Salton didn't issue any new debt and no one wanted to buy their old debt (and the current debt holders didn't really want to sell since they'd get next to nothing for it anyway). "
That bolded part is exactly what I'm talking about. If the market value of the firm's bonds significantly decreases, that represents an increase in the firm's cost of debt. You can look at the quoted prices of the firm's bonds and calculate the YTM of those bonds, which represents the firm's cost of debt.
Here's some evidence:
In their 2004 10-K (for the year ended July 3, 2004), Salton disclosed that the fair value of their senior subordinated debt was $225.3 million, compared to $274.9 million a year earlier. That significant drop in the fair value of the debt represents a significant increase in the firm's cost of debt - the discount rate (or YTM) that equates the future cash flows to the price of the bonds is the firm's cost of debt.
What is your evidence of the market value of the bonds not changing?
Edited to add:
I just looked up some bond rating changes for Salton. It looks like they had to big issues outstanding recently, one maturing in December 2005 and one maturing in April 2008. The December 2005 bond had the following rating changes (from S&P):
9/25/2003: B-
2/11/2004: CCC+
5/11/2004: CCC-
The ratings for the 2008 maturity bond have the same downward pattern from late 2003 to mid-2004. I think this is more evidence that the firm's cost of debt did, in fact, increase over time as their performance declined. You will admit that a firm's cost of debt is increasing as their credit rating decreases, right?
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