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Credit Analysis. Chapter 7 Robinson, Munter, Grant. Learning Objectives. Understand debt instruments, accounting disclosures and claim status Understand interest rates and risk considerations Understand bond ratings Perform credit analysis Understand off-balance-sheet financing.
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Credit Analysis Chapter 7 Robinson, Munter, Grant
Learning Objectives • Understand debt instruments, accounting disclosures and claim status • Understand interest rates and risk considerations • Understand bond ratings • Perform credit analysis • Understand off-balance-sheet financing Chapter 7
Nature of Debt Instruments • Creditors receive interest and principal payments they have been promised • Creditors do not share in the profits of the firm • Credit-granting decisions are based on financial statement analysis and commercial credit ratings • Including off-balance-sheet financing Chapter 7
Debt Covenants • Protect lender/bond investor by restricting certain activities (i.e., dividend payments) • Intended to provide an early warning system for loans that may be in danger • May result in higher bond rating and lower interest rate Chapter 7
Bonds • Indenture is the bond document • Principal (par or face value) is the amount to be repaid, basis for interest payments • Issued in $1,000 increments • 10-, 20-, 30-year maturities • Coupon or stated rate is the interest rate • Secured or unsecured (debenture) Chapter 7
Bonds • Sinking fund – used to pay off the loan • Puttable or redeemable at the purchaser’s option • Callable – at the issuer’s option • Convertible – into another security • Senior vs. junior Chapter 7
Bond Selling price • Present value of principal and interest payments • Par, at face value • Discount • Stated rate < investor’s required rate of return • Premium • Stated rate > investor’s required rate of return Chapter 7
Interest rates • Market rate = Risk free rate + Risk premium • Risk free rate ƒ(inflation rate and investor’s desired “real” return) • Risk premium – additional return, compensation for uncertainty Chapter 7
Bond investment risks • Default risk – issuer unable to make payments • Interest rate risk – potential variation in market rates • Reinvestment rate risk – investor’s ability to reinvest coupon payments at the same rate • Call risk – possibility that issuer will redeem the bond • Purchasing power risk – yield < inflation • Currency risk – for foreign bonds Chapter 7
Accounting for Debt Instruments • Original cost/consideration received • Minus principal payments • Plus discount amortization • Less premium amortization • Example: • 5-year, $10,000,000 bond • 4% semiannual interest payment • 5% prevailing market rate Chapter 7
Bond example • Issue price = $9,227,827 • Present value of interest, $3,088,694 • Present value of principal, $6,139,133 • Discount = $772,173 • Represents additional interest • Initially report: Bond par value $10,000,000 Unamortized discount (772,173) Bond Carrying value $ 9,227,827 Chapter 7
Bond example Chapter 7
Bond example • Market interest drops to 3% • Issue price = $ 10,853,020 • Present value of interest, $3,412,081 • Present value of principal, $7,440,939 • Premium = $853,020 • Represents a reduction in interest • Initially report: Bond par value $10,000,000 Unamortized premium 853,020 Bond Carrying value $10,853,020 Chapter 7
Bond example Chapter 7
Credit rating • Rely on qualitative and quantitative analyses • Standard & Poor’s (AAA to D) • Intermediate “+/-” scores • Moody’s (Aaa to C) • Intermediate “1,2,3” scores • Fitch (AAA to D) Chapter 7
Standard & Poor’s rating method • EBIT interest coverage • EBITDA interest coverage • Funds from operations/Total debt % • Free operating cash flow/Total debt % • Return on capital % • Operating income/Sales • Long-term debt/Capital • Total debt/Capital Chapter 7
Financial distress • Chapter 11 bankruptcy is a financial reorganization in which the company continues to operate and works with creditors to formulate repayment plans. • Chapter 7 bankruptcy is a complete liquidation in which the firm ceases operations and sells all assets. • Financial distress can be predicted. Chapter 7
Prediction of financial distressUnivariate models • Beaver (1966) relied on • Cash flow to total debt • Net income to total assets • Total debt to total assets • Working capital to total assets • Current ratio • No-credit (defensive) interval Chapter 7
Prediction of financial distressMultivariate models • Altman Z-score • (Current assets – current liabilities)/total assets • Retained earnings/Total assets • EBIT/Total assets • Preferred and common stock market value/Book value of liabilities • Sales/Total assets • Nokia = 9.88 • Motorola = 1.71 (below the 2.99 nonbankrupt benchmark) Chapter 7
Motorola Liabilities Chapter 7
Motorola, Note 3 Chapter 7
Motorola, Note 3 Chapter 7
Motorola, Note 8Off-balance-sheet financing • “At December 31, 2001, future minimum lease obligations, net of minimum sublease rentals, for the next five years and beyond are as follows: 2002—$150 million; 2003—$117 million; 2004—$97 million; 2005—$76 million; 2006—$63 million; beyond—$90 million.” • The present value of these payments, at 7%, is $484 million • Inclusion of these items increases debt by 5% Chapter 7
Nokia Liabilities Chapter 7
Nokia debt note detail Chapter 7
Elements of Free Operating Cash Flow Chapter 7
Debt Analysis Ratios Chapter 7
Additional considerations • Mezzanine items • Could be debt or equity • Off-balance-sheet liabilities • Operating leases • Contingent liabilities • Environmental liabilities Chapter 7
Summary • Debt, interest, risk and covenants • Bonds • Discount and premium • Risk analysis • Financial statement presentation • Financial statement analysis Chapter 7
