Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D....
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Transcript of Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D....
Prepared by: Nir Yehuda
With contributions by
Stephen H. Penman – Columbia University
Peter D. Easton and Gregory A. Sommers - Ohio State University
Luis Palencia – University of Navarra, IESE Business School
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-3
What you will learn from this chapterWhat you will learn from this chapter
• How default risk determines the price of credit (the cost of debt
capital)
• What determines default risk
• How default risk is analyzed
• How credit scoring models work
• The difference between Type I and Type II errors is predicting
defaults
• How pro forma analysis aids in assessing default risk
• How value-at-risk analysis is used to assess default risk
• How financial planning works
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-4
Default Risk and Default PremiumsDefault Risk and Default Premiums
• Required Return on Debt = Risk-free Rate + Default Premium
• The default premium is determined by the risk that the debtor could default
• Similar terms: Required return on debt
Cost of debt
Price of credit
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-5
The Suppliers of CreditThe Suppliers of Credit
• Public debt market investors who include (long-term) bondholders and (short-term) commercial paper holders.
• Commercial banks that make loans to firms.
• Other financial institutions such as insurance companies, finance houses and leasing firms make loans, much like banks, but usually with specific assets serving as collateral.
• Suppliers to the firm who grant (usually short- term) credit upon delivery of goods and services.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-6
Ratio Analysis for Default EvaluationRatio Analysis for Default Evaluation
Steps:
1. Reformulate financial statements
2. Calculate ratios
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-7
Reformulating the Balance Sheet for Credit AnalysisReformulating the Balance Sheet for Credit Analysis
The key idea in the reformulation of the balance sheet is to order assets by liquidity and liabilities by maturity. Annotate as you reformulate.
Issues:
• Detail on different classes of debt and their varying maturities is available in the debt footnotes; this detail can be brought on to the face of reformulated statements.
• Debt of unconsolidated subsidiaries (where the parent owns less that 50%, but has effective obligations) should be recognized.
• Long-term marketable securities are sometimes available for sale in the short-term if a need for cash arises.
• Long-term debt (of similar maturity) can be presented on a net basis.
• Remove deferred tax liabilities that are unlikely to reverse, from liabilities to shareholders’ equity.
• Add the LIFO reserve to inventory and to shareholder’s equity to convert LIFO to a FIFO basis.
• Off-balance-sheet debt should be recognized on the face of the statement.
• Contingent liabilities that can be estimated should be included in the reformulated statements.
• The risk in derivatives and other financial instruments should be noted.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-8
Off-Balance-Sheet FinancingOff-Balance-Sheet Financing
• Off-balance-sheet financing transactions are arrangements to finance assets and create obligations that do not appear on the balance sheet.
• Examples:Operating leasesAgreements and commitments:
• third-party agreements
• through-put agreements
• take-or-pay agreements
• repurchase agreements
• sales of receivables with recourseSpecial purpose entities not consolidatedUnfunded pension liabilities not bookedGuarantees of third-party or related-party debtPositions in derivatives off balance sheet
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-9
Reformulated Income Statements and Cash Flow Reformulated Income Statements and Cash Flow StatementsStatements
Income Statement:
• Distinguish income from operations that “covers” net financial expense
The reformulation follows that for profitability analysis in Chapter 9
Cash Flow Statement:
• Distinguish (unlevered) cash flow from operations that can be used to make payments on debt
The reformulation follows that in Chapter 10
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-10
Ratio Analysis: Short-Term Liquidity RatiosRatio Analysis: Short-Term Liquidity Ratios
• Liquidity Stock Measures
Current AssetsCurrent Ratio=
Current Liabilities
Cash+Short-term Investments+ReceivablesQuick or Acid Test Ratio=
Current Liabilities
Cash+Short-term InvestmentsCash Ratio=
Current Liabilities
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-11
Ratio Analysis: Short-Term Liquidity RatiosRatio Analysis: Short-Term Liquidity Ratios
• Liquidity Flow Measures
Cash Flow from OperationsCash Flow Ratio=
Current Liabilities
Cash+Short-term Investments +ReceivablesDefensive Interval= ×365
Capital Expenditures
Unlevered Cash Flow fromCash Flow to Capital Expenditures=
Operations
Capital Expenditures
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-12
Ratio Analysis: Long-term Solvency RatiosRatio Analysis: Long-term Solvency Ratios
• Solvency Stock Measures
Total Debt Current+Long-termDebt to Total Assets=
Total Assets Liabilities+Total Equity
Total DebtDebt to Equity=
Total Equity
Long-term DebtLong-term Debt Ratio=
Long-term Debt + Equtiy
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-13
Ratio Analysis: Long-term Solvency RatiosRatio Analysis: Long-term Solvency Ratios
• Solvency Flow Measures
Operating IncomeInterest Coverage=
Net Interest Expense
Times Interest Earned
Unlevered Cash Flow from OperationsInterest Coverage=
Net Cash InterestCash Basis
Operating Income+Fixed Fixed Charge Coverage=
Charges
Fixed Charges
Unlevered Cash Flow from Operations + Fixed ChargesFixed Charge Coverage=
Fixed Charges
Cash Basis
Unlevered Cash Flow from OperationsCFO to Debt=
Total Debt
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-14
Ratio Analysis: Operating RatiosRatio Analysis: Operating Ratios
Poor profitability increases the likelihood of default.
So the profitability analysis of Chapter 11 and the risk analysis of Chapter 18 are inputs into credit analysis. Watch particularly for declines in
• RNOA
• Operating profit margins
• Sales growth
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-15
Forecasting and Credit RiskForecasting and Credit Risk
The Prelude:
• Know the business
• Appreciate the “moral hazard” problem of debt
• Understand the financing strategy
• Understand the current financing arrangements
• Understand the quality of the firm’s accounting
• Understand the auditor’s opinion, particularly any qualification to the opinion
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-16
Forecasting Default with Credit ScoringForecasting Default with Credit Scoring
Credit scores combine a number of indicators into one score that estimates the probability of default.
Credit Scoring Methods:
• Multiple Discriminate Analysis (MDA)
• Logit Analysis
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-17
Multiple Discriminate AnalysisMultiple Discriminate Analysis (Z-scoring) (Z-scoring)
Original Altman Model:
Working Capital Retained EarningsZ-score=1.2 +1.4
Total Assets Total Assets
Earnings Before Interest and Taxes+3.3
Total Assets
Market Value of Equity+0.6
Book Value of Liabilities
+1.0
Sales
Total Assets
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-18
Logit Scoring ModelLogit Scoring Model
Original Ohlson Model:
Total Liabilitiesy = -1.32 - 0.407 Size + 6.03
Total Assets
Working Capital Current Liabilities-1.43 + 0.0757
Total Assets Current Assets
Net Income Working Cap-2.37 - 1.83
Total Assets
ital Flow from Operations
Total Liabilities
One if net income was negative for the last two years +0.285
Zero if net income was not negative for the last two years
One if total liab-1.72
ilities exceed total assets
Zero if total liabilities do not exceed total assets
Change in Net Income-0.521
Sum of absolute values of current and prior years' net incomes
2.718282ely approximat is e wheree1
1Bankruptcy ofy Probabilit
y-
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-19
Credit Scoring: Prediction Error AnalysisCredit Scoring: Prediction Error Analysis
• Type I error: Classifying a firm as not likely to default when it actually does default
• Type II error: Classifying a firm as likely to default when it does not default
• Trade off Type I and Type II errors: choose a cut- off score that minimizes the cost of errors
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-20
Full Information Forecasting: Using Pro Forma Analysis for Default Full Information Forecasting: Using Pro Forma Analysis for Default ForecastingForecasting
PPE Inc.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Scenario 1: Sales (growth = 5% per year) 124.90 131.15 137.70 144.59 151.82 159.41 Core operating income (PM = 7.85%) 9.80 10.29 10.81 11.35 11.92 12.51 Financial income (expense) (0.70) (0.77) (0.57) (0.35) (0.10) 0.18 Net income 9.10 9.52 10.24 11.00 11.82 12.69 Net operating assets (ATO = 1.762) 74.42 78.15 82.05 86.16 90.46 94.99 Net financial assets (7.70) (5.71) (3.47) (0.97) 1.81 4.91 Common equity 66.72 72.44 78.58 85.19 92.27 99.90 Free cash flow 5.28 6.57 6.90 7.25 7.61 7.99 Dividend 5.28 3.81 4.10 4.40 4.73 5.08 Cash Available for Debt Service 0.0 2.76 2.80 2.85 2.88 2.91 ______________________________________________ Debt to Total Assets 10.3% 7.3% 4.3% 1.1% 2.0% 5.2% Debt to Equity 11.5% 7.9% 4.4% 1.1% 2.0% 4.9% Interest Coverage 14.0 13.4 19.0 32.4 19.2 Fixed Charge Coverage 4.7 4.9 5.0 5.1 RNOA 14.0% 13.8% 13.8% 13.8% 13.8% 13.8% ROCE 14.5% 14.3% 14.1% 14.0% 13.9% 13.8% Debt Service Requirement 0.0 0.0 0.0 0.0 0.0 0.0 _____________________________________________________________________________________________
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-21
Using Pro Forma Analysis for Default ForecastingUsing Pro Forma Analysis for Default Forecasting
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Scenario 2: Sales (decline= 5% per year) 124.90 118.66 112.72 107.09 101.73 96.65 Core operating income (PM = 1%) 9.80 1.19 1.13 1.07 1.02 0.97 Financial income (expense) (0.70) (0.77) (0.69) (0.60) (0.52) (0.42) Net Income 9.10 0.42 0.44 0.47 0.50 0.55 Net operating assets 74.42 74.00 73.60 73.20 72.80 72.40 Net financial assets (7.70) (6.86) (6.02) (5.15) (4.25) Default Common equity 66.72 67.14 67.58 68.05 68.55 Default Free cash flow 5.28 1.61 1.53 1.47 1.42 1.37 Dividend 5.28 0.0 0.0 0.0 0.0 0.0 Cash Available for Debt Service 0.0 1.61 1.53 1.47 1.42 1.37 ______________________________________________ Debt to Total Assets 10.3% 9.3% 8.2% 7.0% 5.8% Debt to Equity 11.5% 10.2% 8.9% 7.6% 6.2% Interest Coverage 14.0 1.5 1.6 1.8 2.0 Fixed Charge Coverage 1.7 1.7 1.7 1.7 RNOA 14.0% 1.6% 1.5% 1.5% 1.4% 1.3% ROCE 14.5% 0.6% 0.7% 0.9% Debt Service Requirement 0.0 0.0 0.0 0.0 4.25 Default _____________________________________________________________________________________________
PPE Inc.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-22
Default PointsDefault Points
Default occurs when cash available for debt service is less than the debt service requirement.
Payments Lease
Payments PrincipalNet Required
Payments Dividend Preferred andInterest RequiredtRequiremen ServiceDebt
DividendsNet -NOA-OI
DividendsNet - FlowCash FreeServiceDebt for AvailableCash
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-23
Value-at-Risk Profiles for Default ForecastingValue-at-Risk Profiles for Default Forecasting
Steps:
1. Generate profiles of cash available for debt service for a full set of scenarios from pro forma analysis
2. Establish the debt service requirement
3. Identify the default point where cash available for debt service is below the debt service requirement, and so identify the default scenarios
4. Assess the probability of the set of default scenarios occurring
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-24
Value-at-Risk ProfileValue-at-Risk Profile
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.
19-25
Liquidity Planning and Financial StrategyLiquidity Planning and Financial Strategy
• A default strategy is a strategy to avoid default
• Pro forma analysis of default points can be used as a planning tool to avoid default
Modify plans to increase liquidity in
order to avoid default and build those plans
into the financial strategy pro forma
