This is a common exercise to determine amounts due. As a rule, the rate used should match the characteristics of the cash flows to be discounted. In practice, cash flows may comprise more than one type of debt or a hybrid of debt and equity or equity only.
We were presented with an assignment to calculate the interest rate applicable to first lien debt for an apartment project in bankruptcy. The debtor had proposed a new interest rate for the existing first lien note on its apartment project. Our client, the existing first lien holder, would have been forced to accept this rate under a “cram down” but asked for our opinion as to the appropriate rate.
Given a recent appraisal for the apartments, we calculated the loan to value ratio and determined it exceeded the 75% ratio typical for the geographic market. We also determined that mezzanine or second lien debt was available in the market at understandably higher interest rates.
Our analysis calculated the amount of first lien debt up to the maximum level, which was 75% of the appraised value of the apartments. That portion was priced at the first lien rate for the geographic area. We then determined the remaining amount of existing debt and determined that portion would be priced as mezzanine or second lien debt at a considerably higher interest rate.
The weighted average interest rate was developed from the debt amounts and rates of the typical first lien combined with mezzanine rates. The weighted average represented the fair market value interest rate for the total existing debt. This weighted average rate, when applied to the existing debt and compared to the pro forma cash flows, made the plan not feasible.
Breaking the cash flow into its constituent portions of debt or equity allows one to develop and blend the correct returns into the discount rate.