Chapter 24 Principles of Corporate Finance Eighth Edition Credit Risk Slides by Matthew Will...

Chapter 24

Principles of

Corporate FinanceEighth Edition

Credit Risk

Slides by

Matthew Will

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin


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McGraw-Hill/Irwin

Topics Covered

The Value of Corporate DebtBond Ratings and the Probability of DefaultPredicting the Probability of DefaultValue at Risk


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McGraw-Hill/Irwin

Valuing Risky Bonds

The risk of default changes the price of a bond and the YTM.

Example

We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value?

A:


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McGraw-Hill/Irwin

Valuing Risky Bonds

Example

We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value?

A: Bond Value Prob

1,050 .80 = 840.00

500 .20 = 100.00 .

940.00 = expected CF

%3.171895

1050

895$05.1

940

YTM

Value


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McGraw-Hill/Irwin

Valuing Risky Bonds

Example – Continued

Conversely - If on top of default risk, investors require an additional 3 percent market risk premium, the price and YTM is as follows:

%7.20100.870

1050

00.870$08.1

940

YTM

Value


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McGraw-Hill/Irwin

Interest Rates, Risk, and Maturity

0

1

2

3

4

5

1 3 5 7 9 11 13 15 17 19 21 23 25

Leverage = 100%Leverage = 60%Leverage = 40%Leverage = 20%

Difference between promised yield (YTM) on bond and risk-free rate, percent

Maturity, years


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McGraw-Hill/Irwin

Key to Bond Ratings

Moody's S&P's & Fitch

Investment GradeAaa AAAAa AA A A

Baa BBBJunk Bonds

Ba BB B B

Caa CCCCa CC C C

The highest quality bonds are rated triple-A.

Investment grade bonds have to be equivalent of

Baa or higher. Bonds that don’t make this cut are called “high-yield” or

“junk” bonds.


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McGraw-Hill/Irwin

Bond Ratings and Financial Ratios

Ratio AAA AA A BBB BB B CCCEBIT interest cover * 21.4 10.1 6.1 3.7 2.1 0.8 0.1return on capital % 34.9 21.7 19.4 13.6 11.6 6.6 1Gross profit margin % 27 22.1 18.6 15.4 15.9 11.9 11.9Total debt/capital % 22.9 37.7 42.5 48.2 62.6 74.8 87.7

* Earnings before interst and tax divided by interest

Three years of median ratio data by bond rating (1998 – 2000).


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McGraw-Hill/Irwin

Bond Ratings and Default

Rating at Time of Issue

1 Year after issue

5 Years after Issue

10 Years after Issue

AAA 0 0.1 0.5AA 0 0.3 0.9A 0.1 0.7 2

BBB 0.4 3.4 6.9BB 1.4 12.4 21B 6.1 26.8 35.4

CCC 30.9 53 58.4

Percentage Defaulting Within

Default rates of corporate bonds 1981-2003 by S&P’s rating at time of issue


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McGraw-Hill/Irwin

Bond Ratings and Yield Spreads

0

2

4

6

8

10

12

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

Moody's Aaa

Moody's Baa

High yield - "Junk" bonds

Yie

ld s

prea

d, p

erce

ntYield spreads

Note these are promised yields Actual Returns?


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McGraw-Hill/Irwin

Credit Analysis

Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.

assets total

sales1.0+

sliabilitie total

equity sr'shareholde.42+

assets total

EBIT3.1+

assets total

earnings retained85.

assets total

NWC.72=Z

formula Score Altman Z


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McGraw-Hill/Irwin

Market Based Analysis KMV

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

27/0

9/200

1

1/11

/2001

7/12

/2001

15/0

1/200

2

21/0

2/200

2

28/0

3/200

2

3/5/2

002

10/6

/2002

19/0

7/200

2

Market value of assets

Default points

Val

ue, $

mil

lion

sThe market value of WorldCom assets, as default approached

Default date


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McGraw-Hill/Irwin

Default Probability

0

5

10

15

20

25

27/0

9/200

1

1/11

/2001

7/12

/2001

15/0

1/200

2

21/0

2/200

2

28/0

3/200

2

3/5/2

002

10/6

/2002

19/0

7/200

2

Prob

abil

ity

of d

efau

lt

over

nex

t yea

rMoody’s estimate of WorldCom’s probability of default

Default date


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McGraw-Hill/Irwin

Value at Risk (VaR)

Value at Risk = VaR

Newer termAttempts to measure riskRisk defined as potential loss

FactorsAsset valueDaily VolatilityDays Confidence interval


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McGraw-Hill/Irwin

Value at Risk (VaR)

Standard Measurements10 days

99% confidence interval

VaR

1010 day

33.2%99

easset valu)33.2( 10 VaR


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McGraw-Hill/Irwin

Value at Risk (VaR)Example

You own a $10 mil portfolio of IBM bonds. IBM has a daily volatility of 2%. Calculate the VaR over a 10 day time period at a 99% confidence level.

%74.14

33.20632.)%(99

621,473,1$

000,000,101473.

VaR

%32.6

1002.10


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McGraw-Hill/Irwin

Value at Risk (VaR)

ExampleYou also own $5 mil of AT&T, with a daily volatility of

1%. AT&T and IBM have a .7 correlation coefficient. What is the VaR of AT&T and the combined portfolio?

405,368$

621,473,1$

&

TAT

IBM

VaR

VaR

026,842,1$& IBMTATVaR

379,751,1$PortfolioVaR

647,90$BenefitationDiversific


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McGraw-Hill/Irwin

Ratings Changes

Start of year, % AAA AA A BBB BB B CCC DefaultAAA 92.08 7.09 0.63 0.15 0.06 0 0 0AA 0.62 90.83 7.76 0.59 0.06 0.1 0.02 0.01A 0.05 2.09 91.37 5.79 0.44 0.16 0.04 0.05

BBB 0.03 0.21 4.1 89.38 4.82 0.86 0.24 0.37BB 0.03 0.08 0.4 5.53 83.25 8.15 1.11 1.45B 0 0.08 0.27 0.34 5.39 82.41 4.92 6.59

CCC 0.1 0 0.29 0.58 1.55 10.54 52.8 34.14

Rating at end of year


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McGraw-Hill/Irwin

Yields and Ratings

Rating after 1-year

Percent yield for given

rating

AAA 4.43AA 4.56A 4.8BBB 5.4BB 9.45B 11.7CCC 15.15Default -

average yields for rated bonds October 2003

Alcan bond price changes, relative to changes in the bond rating

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Chapter 24 Principles of Corporate Finance Eighth Edition Credit Risk Slides by Matthew Will...

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