Chapters 10 and 12

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Chapters 10 and 12

• Credit Analysis and Distress Prediction Corporate
  Financing Policies
• November 14, 2007

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Todays 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?

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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 companys
  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 firms 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 Moodys and Standard
  and Poors
• 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 Category90-03
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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 firms financial
  ratios
• Z-score is one of the most widely used

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Bankruptcy risk

• Z-scores 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

• Altmans 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 ZZ2.99 in between is the zone of ignorance.
• These factors meant to capture firms liquidity,
  profitability, solvency, and activity ratios.

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Worldcoms Z-Score
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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
• SP 500 - 1.73
• DJIA - 1.75
• Nasdaq - .33
• What accounts for the difference?

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Explanations for Differences in Capital Structure

• 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.

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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 ROArd
• 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 MA
• 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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Dividend Policy

• 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?

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Dividend Payout Ratios forSelected Industries
Industry Payout ratio Banking 38.29 Computer
Software Services 13.70 Drug 38.06 Electric
Utilities 67.09 Semiconductors 24.91 Steel 51.
96 Tobacco 55.00 Water 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
Repurchases Buying own stock back from
stockholders.

• 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.

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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 signalmgmt. 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