chapters 10 and 12 credit analysis and distress prediction
TRANSCRIPT
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Chapters 10 and 12
Credit Analysis and Distress Prediction Corporate Financing Policies
November 14, 2007
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Today’s Topics
Credit Analysis Debt Rating Process Distress Prediction Corporate Financing Policies
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Credit Analysis
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What risks should a credit analyst care about?
Credit Risk - concerns the firms’ ability to continue to make interest and principal payments on borrowings
Bankruptcy risk - concerns the firms’ ability to remain a going concern and avoid eventual liquidation
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Who cares about Creditworthiness?
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Credit Markets How (other than through equity) does a firm finance its
asset needs?
How Who Credit Analysis
Buy on credit Supplier Supplier’s policies/ratings
Take out a loan Bank Bank Criterion
Sell Commercial paper
Public Market Rating Agencies and Fixed Inc. Analysts
Sell Bonds Public Market Rating Agencies and Fixed Inc. Analysts
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Credit Process
Determine the purpose of loan Assess Creditworthiness Determine Structure of Debt
Term, security, covenants, etc. Determine Cost of Debt
Risk v. Reward Finalize loan Monitor
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Assessing Creditworthiness
Fundamental Analysis Strategy Analysis Accounting Analysis Financial Statement Analysis Assessment of management
Forecasts and Sensitivity Analysis
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Financial Analysis
Focus in credit analysis is on ability to repay debts Liquidity Ratios – ability of the firm to pay bills
due in the next year with current assets or cash flow that will be generated in the next year
Solvency Ratios - profit or cash flow relative to debt service and other requirements
Historical and forecasted
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Financial Analysis -Liquidity Ratios Liquidity ratios can be viewed from two
perspectives As efficiency ratios that assess the company’s
optimal working capital management (turnover ratios)
As ratios that assess the ability of the company to survive (i.e. pay its bills) in the coming period or periods
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Liquidity Ratios
Liquidity Ratios Current Ratio Quick Ratio Cash Ratio Operating Cash Flow Ratio
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Short-term liquidity risk
Interpreting current ratio (and other similar liquidity ratios): What do these ratios intend to capture? What is the implicit
assumption?
What is the benchmark for these ratios? How high is high?
How to use these ratios?
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Ratios to measure long-term solvency risk Solvency (or leverage) ratios provide us with
information about The extent to which the firm’s assets are financed by
borrowed money The extent to which the borrowed money has required
interest payments
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Ratios to measure long-term solvency risk Long-term debt to total capitalization Debt to equity Liabilities to assets Interest coverage (EBIT /Interest Expense) Operating cash flow to total liabilities
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Long-term solvency risk
What will solvency ratios NOT tell you?
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Liquidity and Solvency Ratios
Use these ratios judiciously. Interpret them in the context of your specific case, and in conjunction with other relevant information.
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Forecasts
Forward looking view of ability to repay Sensitivity/Scenario Analysis
Assess Cash Flow – is it adequate to allow repayment? CF from Operations/Average CL CF from Operations/Average Total Liabilities CF from Operations/Average Cap. Exp.
Capacity for Debt Debt Ratios Interest Coverage
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Determine Loan Type and Structure Loan Type and Term
Open line of credit Revolving line of credit Working Capital loan Term loan Mortgage
Security - receivables, inventory, equipment and machinery, land
Pricing Covenants
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Pricing
Key variable is level of risk involved Term Security Creditworthiness
Often stated as percent above prime or LIBOR (London Interbank Offered Rate)
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Covenants
Means of protection and monitoring for lender Financial covenants targeted to identified
risks Minimum net worth Minimum coverage Minimum liquidity Limits on relative liabilities or spending
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Debt Rating Process
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Debt Ratings
Public markets need means to assess and monitor credit risk
Two major rating agencies: Moody’s and Standard and Poor’s plus Fitch, smaller agency
Ratings Process Fundamental Analysis Detailed forecasts 3-5 years Detailed review of risks and mitigation strategies Application of models
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Ratings Models
Proprietary Models used by agencies and firms Researchers have estimated models Key Characteristics
Size Subordination status of debt Leverage Systematic risk Profitability Unsystematic risk Riskiness of profit stream Interest coverage
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Ratings ParametersMedian Financial Ratios by Rating Category:90-
03 S&P Moody’s Total
Revenue
ROA Debt/
Assets
Interest
Coverage
AAA Aaa 28.8b 9.4% 24.2% 23.72
AA Aa 12.5b 6.7% 27.4% 12.41
A A 8.3b 4.7% 30.5% 9.83
BBB Baa 4.6b 2.7% 33.3% 6.80
BB Ba 2.2b 1.6% 43.4% 5.61
B B 1.0b -3.2% 61.5% 2.24
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Ratings and Yields
Yields will reflect ratings and particular characteristics of bonds
Significant difference between investment grade (BBB and above) and non investment grade
Secondary markets will reflect ratings and circumstance changes occurring after issuance
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Distress Prediction
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Bankruptcy Risk Analysis
Can we predict future bankruptcy? Not exactly, but developing a reasonable
methodology. Various algorithms have been devised to
predict bankruptcy probability using firm’s financial ratios Z-score is one of the most widely used
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Bankruptcy risk
Z-score’s basic idea: For each bankrupt firm, find a similar sized non-
bankrupt firm in the same industry. Perform a Multiple Discriminate Analysis (MDA)
between the bankrupt group and the non-bankrupt group.
Identify the ratios/variables that differ the most between the groups. These ratios/variables are the one that have the most discriminating power for bankruptcy.
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Bankruptcy risk
Altman’s Z-score for manufacturing firms: Z= 1.2 X Working capital / total assets
+ 1.4 X Retained earnings / total assets+ 3.3 X EBIT / total assets+ 0.6 X Market value of equity / BV of debt+ 1.0 X Sales / total assets
Predict: bankrupt if Z<1.81; non-bankrupt if Z>2.99; in between is the “zone of ignorance.”
These factors meant to capture firms’ liquidity, profitability, solvency, and activity ratios.
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Worldcom’s Z-Score
Input Financial Ratio 1999 2000 2001
X1 (1.2) Working capital/Total Assets -0.09 -0.08 0
X2 (1.4) RE/Total Assets -0.02 0.03 0.04
X3 (3.3) EBIT/Total Assets .09 .08 .02
X4 (0.6) Market Value/Total Liab. 3.7 1.2 .50
X5 (1.0) Sales/Total Assets .51 .42 0.3
Z-Score 2.5 1.4 .85
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Bankruptcy Risk Analysis
Problems with Z-Scores Fitting one model to unique situations area between 1.81 and 3.00 is grey Not all firms report required data
Best use of Z-Scores Gauge of relative financial health If trouble indicated, conduct more detailed
analysis
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Corporate Financing Policies
Capital Structure Optimal mix of debt and equity
Dividend Policy Whether to pay and what amount
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Debt Policy
What are debt/equity ratios today? Total ST & LT debt / common equity
S&P 500 - 1.73 DJIA - 1.75 Nasdaq - .33
What accounts for the difference?
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Interest Tax Shield- Tax savings resulting from deductibility of interest payments.
Financial Risk - Risk to shareholders resulting from the use of debt.
Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.
Explanations for Differences in Capital Structure
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Trade-off Theory of Capital Structure When choosing capital structure, the firm chooses
the debt level that maximizes the market value of the firm
The important point is that there is a tradeoff with increased leverage: firm value increases due to the interest tax shield but decreases due to financial distress cost.
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Trade-off Theory of Capital Structure Shareholders benefit when the firm obtains
funds from borrowing and invests the money in assets that generate a higher return than the after-tax cost of borrowing
ROE > ROA when ROA>rd
Financial leverage can increase the return to shareholders
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Trade-off Theory of Capital Structure But increasing levels of debt increases financial
leverage and increases credit and bankruptcy risk and the chance that the company will become insolvent
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What else might determine CS?Some empirical observations:
Avoidance of equity issuance - most companies do not use seasoned equity offerings outside of M&A
Peer similarity - Most companies tend to end up looking like peer industry members
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What else might determine CS? Accounting performance - Better accounting
performance and more tangible assets result in more debt
Uncertainty - Firms with more volatile underlying real assets tend to have less debt (i.e. growth firms)
Active Market timing - Firms experiencing increasing stock prices tend to issue more debt and more equity
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The decision to pay out earnings versus retaining and reinvesting them. Includes these elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
Dividend Policy
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Dividend Payout Ratios forSelected Industries
Industry Payout ratioBanking 38.29Computer Software Services 13.70Drug 38.06Electric Utilities 67.09Semiconductors 24.91Steel 51.96Tobacco 55.00Water utilities 67.35
What explains differences?
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Setting Dividend Policy
Forecast capital needs over a planning horizon, often 5 years.
Set a target capital structure. Estimate annual equity needs. Generally, some dividend growth rate
emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.
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Stock Repurchases
As an alternative to distributing cash as dividends.
To dispose of one-time cash from an asset sale.
To make a large capital structure change.
Repurchases: Buying own stock back from stockholders.
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Advantages and Disadvantages of Repurchases Advantages
Stockholders have choice Single event vs. recurring dividend Flexibility to use repurchased stock Capital gain treatment vs. dividend Seen as positive signal—mgmt. thinks stock is
undervalued. Disadvantages
Seen as negative – no better alternative use of cash IRS could challenge as avoidance of tax on dividends
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Summary
Credit analysis
Public debt markets and rating process
Distress Prediction
Corporate Financing Policies