91711324 a literature review of concepts of credit ratings and corporate valuation

7/29/2019 91711324 a Literature Review of Concepts of Credit Ratings and Corporate Valuation

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Vinod Gupta School of Management, IIT Kharagpur

AMRP Report:A Literature Review of Concepts of Credit Ratings and Corporate Valuation: Findthe Scope of developing a correlation modelThis report is submitted in partial fulfillment of the requirements for the AMRPEvaluation in the Third Semester at Vinod Gupta School of Management, IIT Kharagpur (2010-2012).

Under the Guidance of

Prof. Arun Kumar Misra VGSoM, IIT KharagpurSubmitted by

Harsh Vyas 10BM60030


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Acknowledgement

I would like to express my gratitude to my faculty guide, Prof. Arun Kumar Misrafor helping me cover this much part of my Advanced Management Research Projectthis far. I would also like to thank my parents, friends, other colleagues and my college faculty who have always been very cooperative whenever I have needed them. In the end I would like to thank all those who have been associated with myAMRP and this Project Report.

Harsh Vyas


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TABLE OF CONTENTSAbstract Credit Ratings Credit Score Various types of Credit Ratings Various Methodologies of Credit Rating Literature Review on Credit Ratings Rating Methods Parameters Issues on Ratings Company Valuations Methods of Corporate Valuations How valuation is linked to rating Rating Vs Valuation: A conclusion


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AbstractCredit Rating of a Bond or Security represents a third party view of the solvency or default probability of the security in question, and in correspondence thecorporate or government entity which has issues those bonds. The world famous credit rating agencies are primarily based out of United States of America. Of them Standards & Poor, Moodys and Fitch are the most relevant. All of them have their subsidiary in India as well. For example, Crisil is a subsidiary of S&P in India. These credit ratings use a lot of acronyms like AAA, AA, A+, BBB etc to denote the credit-worthiness of the bond issuer. In these days of Euro turmoil, eventhe ratings of Sovereign government bonds have come under fire, like what happened with the United States when its Sovereign Bonds/Gilts were de-rated to AA from the Platinum AAA. The direct impact of any rating downgrade be it on a government or a corporate is a direct increase in its cost of debt. A more secure rating means a lesser probability of defaulting and thus the risk premium on interest rates becomes lesser than that on a more risky investment. To ascertain this rating, Credit Rating Agencies use a verity of methods, which include both quantitative as well as qualitative models and sometimes opinion based models too. Theusual parameters that are considered are: County Risk, Market Risk, Industry position, Profitability and peer group comparison all of which can be clubbed as Business Risk and then there is the inherent Financial Risk related to accounting(mal)practices, Governance, Risk tolerance, financial policy, cash flow adequacy, capital structure and liquidity/short term factors. Corporate Valuation Techn

iques try to ascertain the present value of a corporation based on its current economic parameters and future earning potential. They typically use parameters like discounting of future cash flow, dividend discount models, Gordon growth model etc. to find the value of what a corporation is worth right now in its sum total. A direct impact of change in Credit Ratings is the change in its borrowingcost. Which in turn changes the Weighted Average Cost of Capital (WACC). This inturn affects the corporate valuation because any such valuation calculation istypically done keeping in mind actual cost of capital and opportunity cost of assigning the capital into some other corporation. This brings us to the crux of the matter. My aim through this advanced management research project is to analyse the publically available data of a few large Indian/Foreign Corporations and develop a chart where based on the Corporate Valuation Data and Financial Statements we are able to predict Credit Ratings of a Corporate Bond and viceversa. Thi

s correlation model will help us identify underrated/overrated bonds and help usassess fair valuation for the corporate.


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Credit RatingA credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporationor a government. It is an evaluation made by a credit rating agency of the debtissuers likelihood of default. Credit ratings are determined by credit ratingsagencies. The credit rating represents the credit rating agency

s evaluation ofqualitative and quantitative information for a company or government; includingnon-public information obtained by the credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government. The credit rating is used by individuals and entities that purchase the bondsissued by companies and governments to determine the likelihood that the government will pay its bond obligations. Credit ratings are often confused with credit scores. Credit scores are the output of mathematical algorithms that assign numerical values to information in an individual

s credit report. The credit report contains information regarding the financial history and current assets and liabilities of an individual. A bank or credit card company will use the credit score to estimate the probability that the individual will pay back loan or will pay back charges on a credit card. However, in recent years, credit scores have also been used to adjust insurance premiums, determine employment eligibility, asa factor considered in obtaining security clearances and establish the amount o

f a utility or leasing deposit. A poor credit rating indicates a credit rating agency

s opinion that the company or government has a high risk of defaulting, based on the agency

s analysis of the entity

s history and analysis of long term economic prospects. A poor credit score indicates that in the past, other individuals with similar credit reports defaulted on loans at a high rate. The credit score does not take into account future prospects or changed circumstances. For example, if an individual received a credit score of 400 on Monday because he hada history of defaults, and then won the lottery on Tuesday, his credit score would remain 400 on Tuesday because his credit report does not take into account his improved future prospects.

Credit ScoreA credit score is a numerical expression based on a statistical analysis of a pe

rson

s credit files, to represent the creditworthiness of that person. A creditscore is primarily based on credit report information typically sourced from credit bureaus. Lenders, such as banks and credit card companies, use credit scoresto evaluate the potential risk posed by lending money to consumers and to mitigate losses due to bad debt. Lenders use credit scores to determine who qualifiesfor a loan, at what interest rate, and what credit limits. Lenders also use credit scores to determine which customers are likely to


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bring in the most revenue. The use of credit or identity scoring prior to authorizing access or granting credit is an implementation of a trusted system. Creditscoring is not limited to banks. Other organizations, such as mobile phone companies, insurance companies, landlords, and government departments employ the same techniques. Credit scoring also has a lot of overlap with data mining, which uses many similar techniques. FICO is a publicly-traded corporation (under the ticker symbol FICO) that created the bestknown and most widely used credit score model in the United States.

Score interpretationThe first step to interpreting a score is to identify the source of the credit score and its use. There are numerous scores based on various scoring models soldto lenders and other users. The most common was created by Fair Isaac Co. and is called the FICO score. FICO produces scoring models that are most commonly used, and which are installed at and distributed by the three largest national credit repositories in the U.S (TransUnion, Equifax and Experian) and the two national credit repositories in Canada (TransUnion Canada and Equifax Canada). FICO controls the vast majority of the credit score market in the United States and Canada although there are several other competing players that collectively share avery small percentage of the market. In the United States, FICO risk scores range from 300-850, with 723 being the median FICO score of Americans in 2010. Theperformance definition of the FICO risk score (its stated design objective) is t

o predict the likelihood that a consumer will go 90 days past due or worse in the subsequent 24 months after the score has been calculated. The higher the consumer

s score, the less likely he or she will go 90 days past due in the subsequent 24 months after the score has been calculated. Because different lending uses(mortgage, automobile, credit card) have different parameters, FICO algorithms are adjusted according to the predictability of that use. For this reason, a person might have a higher credit score for a revolving credit card debt when compared to a mortgage credit score taken at the same point in time. The interpretation of a credit score will vary by lender, industry, and the economy as a whole. While 620 has historically been a divider between "prime" and "subprime", all considerations about score revolve around the strength of the economy in general and investors

appetites for risk in providing the funding for borrowers in particular when the score is evaluated. In 2010, the Federal Housing Administration (F

HA) tightened its guidelines regarding credit scores to a small degree, but lenders who have to service and sell the securities packaged for sale into the secondary market largely raised their minimum score to 640 in the absence of strong compensating factors in the borrower

s loan profile. In another housing example,Fannie Mae and Freddie Mac began charging extra for loans over 75% of the valuethat have scores below 740. Furthermore, private mortgage insurance companies will not even provide mortgage insurance for borrowers with scores below 660. Therefore, "prime" is a product of the lender

s appetite for the risk profile of theborrower at


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the time that the borrower is asking for the loan. The Credit Information Bureau(India) Limited (CIBIL) was incorporated in 2000 by the Government of India andthe Reserve Bank of India to provide credit information about commercial and consumer borrowers to a limited group of members, including banks, financial institutions, non-banking financial companies, housing finance companies and credit card companies. In the United States, a credit score is a number based on a statistical analysis of a person

s credit files, that in theory represents the creditworthiness of that person, which is the likelihood that people will pay their bills. A credit score is primarily based on credit report information, typically from one of the three major credit bureaus: Experian, TransUnion, and Equifax. Income is not considered by the major credit bureaus when calculating a credit score. There are different methods of calculating credit scores. FICO, the most widely known type of credit score, is a credit score developed by FICO, previouslyknown as Fair Isaac Corporation. It is used by many mortgage lenders that use arisk-based system to determine the possibility that the borrower may default onfinancial obligations to the mortgage lender. All credit scores have to be subject to availability. The credit bureaus all have their own credit scores: Equifax

s ScorePower, Experian

s PLUS score, and TransUnion

s credit score, and each also sells the VantageScore credit score. In addition, many large lenders, including the major credit card issuers, have developed their own proprietary scoring models. Studies have shown scores to be predictive of risk in the underwriting ofboth credit and insurance. Some studies even suggest that most consumers are th

e beneficiaries of lower credit costs and insurance premiums due to the use of credit scores. Usage of credit histories in employment screenings has increased from 19% in 1996 to 42% in 2006. However, credit reports for employment screeningpurposes do not include credit scores. Americans are entitled to one free credit report within a 12-month period from each of the three credit bureaus, but arenot entitled to receive a free credit score. Credit scores are available as anadd-on feature of the report for a fee. This fee is usually around $10, as the FTC regulates this charge, and the credit bureaus are not allowed to charge an exorbitant fee for their credit score. If the consumer disputes an item on a credit report obtained using the free system, under the Fair Credit Reporting Act (FCRA), the credit bureaus have 45 days to investigate, rather than 30 days for reports obtained otherwise. Alternatively, consumers wishing to obtain their creditscores can in some cases purchase them separately from the credit bureaus or ca

n purchase their FICO score directly from Fair Isaac. Under the Fair Credit Reporting Act, a consumer is entitled to a free credit report (but not a free creditscore) within 60 days of any adverse action (e.g. being denied credit, or receiving substandard credit terms from a lender) taken as a result of their credit score. Under the Wall Street reform bill passed on July 22, 2010, a consumer is entitled to receive a free credit score if they are denied a loan or insurance due to their credit score.


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The FICO credit score ranges between 300 and 850. The VantageScore score rangesfrom 501-990 Credit Information Bureau (India) Limited (Cibil) will now providecustomers their credit reports and scores online for Indians too. Individuals can now access these through a threestep process. In the first step, customers would have to fill an online form, with personal details like name, licence numberand contact details. The second step would involve a payment of Rs 450, by way of debit, credit cards, net banking or cash cards. The third step would involve authentication and this would pose five system-generated questions. To prove their authenticity, customers would have to answer at least three questions. The questions would be objective, and would also carry a few options. The questions would be very personal, and can be answered only by real customers. In case the customer fails to answer three questions correctly, he/she would have to go throughthe normal procedure of sending the hard copy of the documents to complete theknow-your-client procedure. Also, while the normal procedure of report generation by Cibil allows customers to pay Rs 142 and just get the report without the score, the online procedure does not provide this option, and the customers wouldhave to pay Rs 450.

What are credit Ratings:Credit ratings are forward looking: As part of its ratings analysis, Standard &Poors evaluates available current and historical information and assesses the potential impact of foreseeable future events. For example, in rating a corporation

as an issuer of debt, the agency may factor in anticipated ups and downs in thebusiness cycle that may affect the corporations creditworthiness. While the forward looking opinions of rating agencies can be of use to investors and market participants who are making long- or short-term investment and business decisions,credit ratings are not a guarantee that an investment will pay out or that it will not default. Credit ratings do not indicate investment merit: While investors may use credit ratings in making investment decisions, Standard & Poors ratingsare not indications of investment merit. In other words, the ratings are not buy, sell, or hold recommendations, or a measure of asset value. Nor are they intended to signal the suitability of an investment. They speak to one aspect of aninvestment decision credit qualityand, in some cases, may also address what investors can expect to recover in the event of default. In evaluating an investment,investors should consider, in addition to credit quality, the current make-up of

their portfolios, their investment strategy and time horizon, their tolerance for risk, and an estimation of the securitys relative value in comparison to othersecurities they might choose. By way of analogy, while reputation for dependability may be an important consideration in buying a car, it is not the sole criterion on which drivers normally base their purchase decisions. Credit ratings arenot absolute measures of default probability: Since there are future events anddevelopments that cannot be foreseen, the assignment of credit ratings is not an exact science. For this reason, Standard & Poors ratings opinions are not intended as guarantees of credit quality or as exact measures of the probability thata particular issuer or particular debt issue will default.


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Instead, ratings express relative opinions about the creditworthiness of an issuer or credit quality of an individual debt issue, from strongest to weakest, within a universe of credit risk. For example, a corporate bond that is rated AA is viewed by the rating agency as having a higher credit quality than a corporate bond with a BBB rating. But the AA rating isnt a guarantee that it will not default,ly that, in the agencys opinion, it is less likely to default than the BBB bond.

Corporate credit ratingsThe credit rating of a corporation is a financial indicator to potential investors debt securities such as bonds. Credit rating is usually of a financial instrument such as a bond, rather than the whole corporation. These are assigned by credit rating agencies such as A. M. Best, Dun & Bradstreet, Standard & Poor

s, Moody

s or Fitch Ratings and have letter designations such as A, B, C. The Standard & Poor

s rating scale is as follows, from excellent to poor: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, B, CCC+, CCC, CCC-, CC, C, D.Anything lower than a BBB- rating is considered a speculative or junk bond. TheMoody

s rating system is similar in concept but the naming is a little different. It is as follows, from excellent to poor: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C. A. M. Best rates from excellent to poor in the following manner: A++, A+, A, A-, B++, B+, B,B-, C++, C+, C, C-, D, E, F, and S. The CTRISKS rating system is as follows: CT3A, CT2A, CT1A, CT3B, CT2B, CT1B, CT3C, CT2C and CT1C. All these CTRISKS grades a

re mapped to one-year probability of default.

Moody

s

S&P

Fitch

Longterm

Shortterm

Longterm

Shortterm

Longterm

Shortterm

Aaa

AAA

AAA

Prime

Aa1 P-1 Aa2

AA+ A-1+ AA

AA+ F1+ AA High grade

Aa3


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AA-

AA-


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A1

A+ A-1

A+ F1 A Upper medium grade

A2

A

A3 P-2 Baa1

AA-2 BBB+

AF2 BBB+

Baa2 P-3 Baa3

BBB A-3 BBB-

BBB F3 BBB-

Lower medium grade

Ba1

BB+

BB+ Non-investment grade speculative

Ba2

BB

BB

Ba3

BBB

BBB B+

B1 Not prime B2

B+

B

B

Highly speculative

B3

B-

B-


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Caa1

CCC+ C CCC C

Substantial risks

Caa2

CCC

Extremely speculative


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Caa3

CCCIn default with little prospect for recovery

CC Ca C

C

DDD

/

D

/

DD

/

In default

/

D

Sovereign credit ratingsAAA AA A BBB BB B CCC no rating

A sovereign credit rating is the credit rating of a sovereign entity, i.e., a national government. The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad. It takes political risk into account. Country risk rankings (June 2011)

Rank Previous

Country

Overall score


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1

1

Norway

92.44

2

6

Luxembourg

90.86

3

2

Switzerland

90.20

4

4

Denmark

89.07

5

3

Sweden

88.72

6

12

Singapore

87.65

7

5

Finland

87.31

8


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7

Canada

87.24

9

6

Netherlands

86.97

10

13

Germany

85.73

The table shows the ten least-risky countries for investment as of June 2011. Ratings are further broken down into components including political risk, economic

risk. Euromoney

s biannual country risk index monitors the political and economic stability of 185 sovereign countries. Results focus foremost on economics, specifically sovereign default risk and/or payment default risk for exporters (a.k.a. "trade credit" risk). A. M. Best defines "country risk" as the risk that country-specific factors could adversely affect an insurer

s ability to meet its financial obligations.

Short-term ratingA short-term rating is a probability factor of an individual going into defaultwithin a year. This is in contrast to long-term rating which is evaluated over along timeframe. In the past institutional investors preferred to consider long-term ratings. Nowadays, short-term ratings


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are commonly used. First, the Basel II agreement requires banks to report theirone-year probability if they applied internal-ratings-based approach for capitalrequirements. Second, many institutional investors can easily manage their credit/bond portfolios with derivatives on monthly or quarterly basis. Therefore, some rating agencies simply report short-term ratings. In addition, the Guide to Credit Rating Essentials points out several key things you should know about credit ratings: Credit ratings are opinions about relative credit risk. Credit ratings are not investment advice, or buy, hold, or sell recommendations. They are just one factor investors may consider in making investment decisions. Credit ratings are not indications of the market liquidity of a debt security or its pricein the secondary market. Credit ratings are not guarantees of credit quality orof future credit risk. Credit Ratings are opinions based on analysis by experienced professionals who evaluate and interpret information received from issuers and other available sources to form a considered opinion. Unlike other types of opinions, such as, for example, those provided by doctors or lawyers, credit ratings opinions are not intended to be a prognosis or recommendation. Instead, theyare primarily intended to provide investors and market participants with information about the relative credit risk of issuers and individual debt issues thatthe agency rates.

Why credit ratings are usefulCredit ratings may play a useful role in enabling corporations and governments t

o raise money in the capital markets. Instead of taking a loan from a bank, these entities sometimes borrow money directly from investors by issuing bonds or notes. Investors purchase these debt securities, such as municipal bonds, expecting to receive interest plus the return of their principal, either when the bond matures or as periodic payments. Credit ratings may facilitate the process of issuing and purchasing bonds and other debt issues by providing an efficient, widely recognized, and long-standing measure of relative credit risk. Investors and other market participants may use the ratings as a screening device to match therelative credit risk of an issuer or individual debt issue with their own risk tolerance or credit risk guidelines in making investment and business decisions.For instance, in considering the purchase of a municipal bond, an investor may check to see whether the bonds credit rating is in keeping with the level of credit risk he or she is willing to assume. At the same time, credit ratings may be u

sed by corporations to help them raise money for expansion and/or research and development as well as help states, cities, and other municipalities to fund public projects.


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Who uses credit ratings

Investors Investors most often use credit ratings to help assess credit risk andto compare different issuers and debt issues when making investment decisions and managing their portfolios. Individual investors, for example, may use creditratings in evaluating the purchase of a municipal or corporate bond from a risktolerance perspective. Institutional investors, including mutual funds, pensionfunds, banks, and insurance companies often use credit ratings to supplement their own credit analysis of specific debt issues. In addition, institutional investors may use credit ratings to establish thresholds for credit risk and investment guidelines. A rating may be used as an indication of credit quality, but investors should consider a variety of factors, including their own analysis.

Intermediaries Investment bankers help to facilitate the flow of capital from investors to issuers. They may use credit ratings to benchmark the relative creditrisk of different debt issues, as well as to set the initial pricing for individual debt issues they structure and to help determine the interest rate these issues will pay. Investment bankers and entities that structure special types of debt issues may look to a rating agencys criteria when making their own decisionsabout how to configure different debt issues, or different tiers of debt. Investment bankers may also serve as arrangers of special debt issues. In this capacity, they establish special entities that package assets, such as retail mortgages

and student loans, into securities, or structured finance instruments, which they then market to investors.


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Credit rating agencies Some credit rating agencies, including major global agencies like Standard & Poors, are publishing and information companies that specialize in analyzing the credit risk of issuers and individual debt issues. They formulate and disseminate ratings opinions that are used by investors and other market participants who may consider credit risk in making their investment and business decisions. In part because rating agencies are not directly involved in capital market transactions, they have come to be viewed by both investors and issuers as impartial, independent providers of opinions on credit risk. Businesses and financial institutions Businesses and financial institutions, especially those involved in credit- sensitive transactions, may use credit ratings to assess counterparty risk, which is the potential risk that a party to a credit agreementmay not fulfill its obligations. For example, in deciding whether to lend moneyto a particular organization or in selecting a company that will guarantee therepayment of a debt issue in the event of default, a business may wish to consider the counterparty risk. A credit rating agencys opinion of counterparty risk can therefore help businesses analyze their credit exposure to financial firms that have agreed to assume certain financial obligations and to evaluate the viability of potential partnerships and other business relationships. Issuers Issuers,including corporations, financial institutions, national governments, states, cities and municipalities, use credit ratings to provide independent views of their creditworthiness and the credit quality of their debt issues.Issuers may alsouse credit ratings to help communicate the relative credit quality of debt issu

es, thereby expanding the universe of investors. In addition, credit ratings mayhelp them anticipate the interest rate to be offered on their new debt issues.As a general rule, the more creditworthy an issuer or an issue is, the lower theinterest rate the issuer would typically have to pay to attract investors. The reverse is also true: an issuer with lower creditworthiness will typically pay ahigher interest rate to offset the greater credit risk assumed by investors.

Rating methodologiesIn forming their opinions of credit risk, rating agencies typically use primarily analysts or mathematical models, or a combination of the two. Model driven ratings. A small number of credit rating agencies focus almost exclusively on quantitative data, which they incorporate into a mathematical model. For example, anagency using this approach to assess the creditworthiness of a bank or other fin

ancial institution might evaluate that entitys asset quality, funding, and profitability based primarily on data from the institutions public financial statementsand regulatory filings. Analyst driven ratings. In rating a corporation or municipality, agencies using the analyst driven approach generally assign an analyst, often in conjunction with a team of specialists, to take the lead in evaluating the entitys creditworthiness. Typically, analysts obtain information from published reports, as well as from interviews and discussions with the issuers management. They use that information to assess the entitys financial condition, operating performance, policies, and risk management strategies.

How agencies are paid for their services Agencies typically receive payment fortheir services either from the issuer that requests the rating or from subscribers who receive the published ratings and related credit reports. Issuer-pay mode

l. Under the issuer-pay model, rating agencies charge issuers a fee for providing a ratings opinion. In conducting their analysis, agencies may obtain information from issuers that


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might not otherwise be available to the public and factor this information intotheir ratings opinion. agency does not rely solely on subscribers for fees, it can publish current ratings broadly to the public free of charge. Subscription model. Credit rating agencies that use a subscription model charge investors and other market participants a fee for access to the agencys ratings. Critics point out that like the issuer-pay model, this model has the potential for conflicts ofinterest since the entities paying for the rating, in this case investors, mayattempt to influence the ratings opinion. Critics of this model also point out that the ratings are available only to paying subscribers. These tend to be largeinstitutional investors, leaving out smaller investors, including individual investors. In addition, rating agencies using the subscription model may have morelimited access to issuers. Information from management can be helpful when providing forward looking ratings. Safeguards for issuer-pay ratings To protect against potential conflicts of interest when paid by the issuer, Standard & Poors hasestablished a number of safeguards. These measures include, for example, a clear separation of function between those who negotiate the business terms for theratings assignment and the analysts who conduct the credit analysis and providethe ratings opinions. This separation is similar in concept to the way newspapers distinguish their editorial and advertising sales functions, since they reporton companies from which they may also collect advertising fees. Another safeguard is the committee process that limits the influence any single person can haveon Standard & Poors ratings opinions. The role of the committee is to review and

assess the analysts recommendation for a new rating or a ratings change as wellas to provide additional perspectives and checks and balances regarding adherence to the agencys ratings criteria.

Rating issuers and issues Credit rating agencies assign ratings to issuers, suchas corporations and governments, as well as to specific debt issues, such as bonds, notes, and other debt securities. Rating an issuer To assess the creditworthiness of an issuer, Standard & Poors evaluates the issuers ability and willingness to repay its obligations in accordance with the terms of those obligations. Toform its ratings opinions, Standard & Poors reviews a broad range of financial and business attributes that may influence the issuers prompt repayment. The specific risk factors that are analyzed depend in part on the type of issuer. For example, the credit analysis of a corporate issuer typically considers many financi

al and nonfinancial factors, including key performance indicators, economic, regulatory, and geopolitical influences, management and corporate governance attributes, and competitive position. In rating a sovereign, or national government, the analysis may concentrate on political risk, monetary stability, and overall debt burden. For high-grade credit ratings, Standard & Poors considers the anticipated ups and downs of the business cycle, including industry-specific and broadeconomic factors. The length and effects of business cycles can vary greatly, however, making their impact on credit quality difficult to predict with precision. In the case of higher risk, more volatile speculative- grade ratings, Standard& Poors factors in greater vulnerability to down business cycles. Rating an issue In rating an individual debt issue, such as a corporate or municipal bond, Standard & Poors typically uses, among other things, information from the issuer andother sources to evaluate the credit quality of the issue and the likelihood of

default. In the case of bonds issued by corporations or municipalities, ratingagencies typically begin with an evaluation of the creditworthiness of the issuer before assessing the credit quality of a specific debt issue. In analyzing debt issues, for example, Standard & Poors analysts evaluate, among other things:


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> The terms and conditions of the debt security and, if relevant, its legal structure. > The relative seniority of the issue with regard to the issuers other debt issues and priority of repayment in the event of default. > The existence of external support or credit enhancements, such as letters of credit, guarantees, insurance, and collateral. These protections can provide a cushion that limits the potential credit risks associated with a particular issue. Recovery of investment after default Credit rating agencies may also assess recovery, which is thelikelihood that investors will recoup the unpaid portion of their principal in the event of default. Some agencies incorporate recovery as a rating factor in evaluating the credit quality of an issue, particularly in the case of non-investmentgrade debt. Other agencies, such as Standard & Poors, issue recovery ratings in addition to rating specific debt issues. Standard & Poors may also consider recovery ratings in adjusting the credit rating of a debt issue up or down in relation to the credit rating assigned to the issuer. Rating structured finance instruments A structured finance instrument is a particular type of debt issue created through a process known as securitization. In essence, securitization involvespooling individual financial assets, such as mortgage or auto loans, and creating, or structuring, separate debt securities that are sold to investors to fundthe purchase of these assets. The creation of structured finance instruments, such as residential mortgage-backed securities (RMBS), asset-backed securities (ABS), and collateralized debt obligations (CDOs), typically involves three parties: an originator, an arranger, and a special purpose entity, or SPE, that issues

the securities. > The originator is generally a bank, lender, or a financial intermediary who either makes loans to individuals or other borrowers or purchasesthe loans from other originators. > The arranger, which may also be the originator, typically an investment bank or other financial services company, securitizes the underlying loans as marketable debt instruments. > The special purpose entity (SPE), generally created by the arranger, finances the purchase of the underlying assets by selling debt instruments to investors. The investors are repaidwith the cash flow from the underlying loans or other assets owned by the SPE. Stratifying a pool of undifferentiated risk into multiple classes of bonds with varying levels of seniority is called tranching. Investors who purchase the senior tranche, which generally has the highest quality debt from a credit perspective and the lowest interest rate, are the first to be repaid from the cash flow ofthe underlying assets. Holders of the next-lower tranche, which pays a somewhat

higher rate, are paid second, and so forth. Investors who purchase the lowest tranche generally have the potential to earn the highest interest rate, but theyalso tend to assume the highest risk. In forming its opinion of a structured finance instrument, Standard & Poors evaluates, among other things, the potential risks posed by the instruments legal structure and the credit quality of the assetsthe SPE holds. Standard & Poors also considers the anticipated cash flow of these underlying assets and any credit enhancements that provide protection againstdefault.

Expressions of change: Outlook and CreditWatch If Standard & Poors anticipates that a credit rating may change in the coming 6 to 24 months, it may issue an updated ratings outlook indicating whether the possible change is likely to be positive, negative, stable, or developing (meaning its uncertain whether a rating mig

or down). Or, if events or circumstances occur that may affect a credit rating in the near term, usually within 90 days, Standard & Poors may place the rating onCreditWatch. Typically, an updated outlook or CreditWatch from Standard & Poorsincludes a rationale for the potential


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change and the extent of the change, up or down, that may occur. However, updating a ratings outlook or placing a rating on CreditWatch does not mean a ratingschange is inevitable. If Standard & Poors has all the information available to warrant a ratings change, it may upgrade or downgrade the rating immediately, without placing the rating on CreditWatch or changing its outlook, to reflect thesecircumstances and its current opinion of relative credit risk. Surveillance: Tracking credit quality Agencies typically track developments that might affect thecredit risk of an issuer or individual debt issue for which an agency has provided a ratings opinion. In the case of Standard & Poors, the goal of this surveillance is to keep the rating current by identifying issues that may result in either an upgrade or a downgrade. In conducting its surveillance, Standard & Poors may consider many factors, including, for example, changes in the business climateor credit markets, new technology or competition that may hurt an issuers earnings or projected revenues, issuer performance, and regulatory changes. The frequency and extent of surveillance typically depends on specific risk. considerations for an individual issuer or issue, or an entire group of rated entities or debt issues. In its surveillance of a corporate issuers ratings, for example, Standard & Poors may schedule periodic meetings with a company to allow management to:> Apprise agency analysts of any changes in the companys plans. > Discuss new developments that may affect prior expectations of credit risk. > Identify and evaluate other factors or assumptions that may affect the agencys opinion of the issuers creditworthiness. As a result of its surveillance analysis, an agency may adj

ust the credit rating of an issuer or issue to signify its view of a higher or lower level of relative credit risk.

Why credit ratings change The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the economy or business environment or morenarrowly focused on circumstances affecting a specific industry, entity, or individual debt issue. In some cases, changes in the business climate can affect thecredit risk of a wide array of issuers and securities. For instance, new competition or technology, beyond what might have been expected and factored into theratings, may hurt a companys expected earnings performance, which could lead to one or more rating downgrades over time. Growing or shrinking debt burdens, heftycapital spending requirements, and regulatory changes may also trigger ratingschanges. While some risk factors tend to affect all issuersan example would be gr

owing inflation that affects interest rate levels and the cost of capitalother risk factors may pertain only to a narrow group of issuers and debt issues. For instance, the creditworthiness of a state or municipality may be impacted by population shifts or lower incomes of taxpayers, which reduce tax receipts and ability to repay debt. When ratings change Credit rating adjustments may play a role in how the market perceives a particular issuer or individual debt issue. Sometimes, for example, a downgrade by a rating agency may change the markets perceptionof the credit risk of a debt security which, combined with other factors, may lead to a change in the price of that security. Market prices continually fluctuate as investors reach their own conclusions about the securitys shifting credit quality and investment merit. While ratings changes may affect investor perception, credit ratings constitute just one of many factors that the marketplace should consider when evaluating debt securities.

Agency studies of defaults and ratings changes To measure the performance of itscredit ratings, Standard & Poors conducts studies to track


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default rates and transitions, which is how much a rating has changed, up or down, over a certain period of time. Agencies use these studies to refine and evolve their analytic methods in forming their ratings opinions. Transition rates canalso be helpful to investors and credit professionals because they show the relative stability and volatility of credit ratings. For example, investors who areobligated to purchase only highly rated securities and are looking for some indication of stability may review the history of rating transitions and defaults as part of their investment research.

Introduction of Corporate Valuation techniques The corporate finance theories and practices have evolved since the 50s from normative to positive approaches to explain why and how investors react to companies decisions and announcements withrespect to companies financial and investment decisions. The ways and the empirical examination provides varying results because different variables suggest different estimates of expected future cash flows and, thus, different market value.The most basic of these models can be written as follows.


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The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.

Thus the discounted present value (for one cash flow in one future period) is expressed as:

where DPV is the discounted present value of the future cash flow (FV), or FVjusted for the delay in receipt; FV is the nominal value of a cash flow amount in a future period; i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full; d is the discount rate, which is i/(1+i), i.e. the interest rate expressedas a deduction at the beginning of the year instead of an addition at the end ofthe year; n is the time in years before the future cash flow occurs.

Theoretically this model has been extended to fit the believed lifecycle of thecompany. In this way the theory can account for different growth rates in the infancy of the company, the maturity " stage of the company, and the decay of the company. The assumption of constant cost of capital over a longer period of timereflects the simplification of the companies values.

The Gordon growth model is a variant of the discounted cash flow model, a methodfor valuing a stock or business. Often used to provide difficult-to-resolve val

uation issues for litigation, tax planning, and business transactions that don

thave an explicit market value. It is named after Myron J. Gordon, who originally published it in 1959. It assumes that the company issues a dividend that has acurrent value of D that grows at a constant rate g. It also assumes that the required rate of return for the stock remains constant at k>g which is equal to the cost of equity for that company. It involves summing the infinite series whichgives the value of price current P.

. Summing the infinite series we get,

In practice this P is then adjusted by various factors e.g. the size of the company.

k denotes expected return = yield + expected growth.


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It is common to use the next value of D given by : D1 = D0(1 + g), thus the Gordon

s model can be stated as

.

Capital Asset Pricing Model (CAPM) The Capital Asset Pricing Model postulates asimple linear relationship between expected rate of return and systematic risk of a security or portfolio. The model is an extension of Markowitzs (1952) portfolio theory. The researchers who are commonly credited with the development of CAPM are Sharpe (1964), Linter (1965) and Black (1972), which is why CAPM is commonly referred to as SLB model. Markowitz (1952) developed a concept of portfolio efficiency in terms of the combination of risky assets that minimizes the risk for a given return or maximizes return for a given risk. Using variance of expected returns as the measure of risk, he shows a locus of efficient portfolios thatminimize risk for a given rate of return. The Capital Asset Pricing Model equation shows the relationship between cost of capital and market returns and takes the following form, E(Ri) = Rf + i (E (RM)- Rf) Where: E is the expectation operator; Ri is the return on equity or portfolio i; RM is the return on the market portfolio; Rf of the risk-free asset; i is a measure of systematic risk on equity or portfolio i. The equation indicates that the expected rate of return on asseti is equal to the rate of return on the risk-free asset plus a risk premium. This is simply a multiple () of the difference between the expected rate of the retu

rn of the market portfolio and the risk-free rate. Arbitrage Pricing Theory (APT) Arbitrage Pricing Theory (APT), developed by Ross (1976), suggests that valuereturn depend on several independent factors rather than a single factor of systematic risk. When these types of models include beta from CAPM they are sometimereferred to as extended CAPM. When beta is excluded they are simply called Arbitrage Pricing Models (APM). A major criticism of these models is that there is no theory to suggest which variables should be included and which variables excluded, and therefore the choice of variables in the past has been at ad- hoc. Ri-Rf=ai + t(RM -Rf,)+si(SMB)


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RM is market return. Rf is the risk-free rate. SML is constructed by taking thereturn of a portfolio of companies in the bottom 50 percentile by market capitalization minus the return of a portfolio of companies in the top 50 percentile bymarket capitalization. Weighted Average Cost of Capital (WACC) Miller and Modigliani (1958, 1963) demonstrated that the value of a company would be unaffectedby either capital structure or dividend policy in the absence of taxes. Once corporate taxes are introduced the capital structure can influence the value of thecompany. Since interest payments can be deducted, the cost of external financing becomes cheaper. The assumptions used are similar to that of the frictionlessworld of CAPM, namely perfect information and perfect capital markets. The relevant formulas of the model are as follows

Kto t Ke (1 t ) D/E( Ke Kd )Where:

Ktot is the total cost of capital for the company; Ke is the cost of capital ofequity; Kd is the cost of capital of debt; D is the value of debt; E is the value of equity; WACCtot is the total weighted cost of capital for the entire company; and WACCe is the weighted cost of capital if the company did not incur debt.Therefore, the value to equity holders will increase by a greater amount when the company incurs debt to finance new projects as compared to the use of internalfinance or the issuance of new equity. In addition, the value to any existing d

ebt holder will decrease with the issuance of new debt by the company.

Investment ModelsThe neo-classical model of investment is based on an explicit model of optimization that relates the desired capital stock to interest rates, output, capital assets and tax policies. The model assumes efficient capital markets and perfect information. All companies have equal access to capital markets regardless of risk, therefore the amount borrowed and the cost of capital will only differ because of difference in investment demand. Irvin Fischer (1930) presents a more in-depth discussion of this model in his book the Theory of Interest. A summary of the theory and an empirical investigation can be found in Jorgenson (1963). Tobin(1969) developed an investment demand model in which net investment


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depends on the ratio of the market value of an asset to its replacement cost. The replacement cost is represented by a "q" ratio, which is why this model is generally referred to as Tobin

s q Model of Investment. This model suggests that the company will continue to invest as long as the market value of the marginal unit of capital exceeds its costs. This leads to an investment model for the company in the following form:

It a

b ( q 1)j j 0

tj

Kt j 1 bk Kt 1 u

Where:

It is the investment expenditure at time t; Kt-1 is the capital stock at time t-1; Kt-j-1 is the capital stock at time t-j-1; a, bj and bk and coefficients; q is Tobin

s q ratio.

Conclusion: Why Credit Ratings Are Still Important in Determining Stock ValuationCredit ratings impact cost of capital and stock valuation in a myriad of ways. Higher ratings not just allow for lower borrowing costs but can be a magnet for additional business and better terms from suppliers. As such, enterprises attemptto maintain their leverage and fixed charge ratios at a desired (target) level,or to improve or take actions to improve their averages to that level. Firms also compare their financial ratios to others in their industry, relative to theirrespective credit ratings. Some entities will be comfortable taking on debt, even though it may mean sacrificing a credit rating, if it means improving returnon invested capital (ROIC). If investors believe a project or acquisition will be value enhancing, bonds will normally be placed at the expected interest rate,and cost of capital remain stable, even if the rating is slightly lowered. If th

e projected capitalization is inconsistent with its current rating, a rating change will most likely take place, and so the Board of Directors must decide if such a project is worth the incremental cash flows over the longer run. If the project or acquisition will bring in long-term value which will restore the capitalization, then perhaps the rating agencies would overlook the temporary blip in the financial structure. Credit ratings are also important in that the rating agencies may have confidential access to information shared by the enterprise whichis not reflected in current risk assessment. In the cost of capital model (encompassing 60+ metrics) we use at CT Capital, the lower the credit rating, the greater the penalty assessment, since the credit rating has a significant effect onthe cost of doing business. For example, many companies selling outside the USrely on the credit rating when basing their purchase decisions. Other companieshave their cost of debt significantly raised or lowered due to a change in their

rating, while financial and regulated companies might be required to commit more capital to subsidiaries if their ratings are lowered. Also, ratings affect theentitys supplier and customer decisions, regarding their willingness to supply or order.


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If a customers ratings are lowered, their business could be negatively affected.For the financial aspect of the business, adverse down-grades could require additional collateral to be placed with creditors and counterparties. The effect ofa change in the credit rating in CT Capitals cost of capital model will thus varyfrom insignificant to very significant. Additionally, many pension funds are prohibited from owning debt below a certain grade, while other funds may own no greater than a small allocation to lower grades. Thus, the higher the grade, the greater the potential demand for an entitys fixed income instruments, and commensurate lower cost of debt. Standard and Poors has published key financial ratios with their commensurate. The greater the leverage and lower the fixed charge coverage, the lower the credit rating, on average. In actuality, a credit rating takes into account many factors, some being non-financial, such as the willingness of an entity to reduce its leverage The credit model we use (as well as credit rating agencies) are far more comprehensive than this table, however these key ratios provide a reasonable guide from which additional credit work can take place.For instance, for us, EBITDA is not part of the credit worksheet as we focus onfree cash flow, including serious adjustments to published financial statements. Also, S&P defines free operating cash flow as cash flow from operating activities minus capital spending. We also make various adjustments to operating cash flows and then add back a percentage of discretionary spending, known as corporate fat. It is where a difference exists between a NSRO rating and our credit worksheet when a rating change is most likely.

Table 1 Key Financial Ratios Standard and Poors:


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Table 2 Intel Implied Credit Based On S&P Key Metrics

Using metrics from S&P Key Financial Ratios (Table 1), we look at Intel in Table2, which S&P assigns a rating of A+; the table reveals Intel is really closer to AAA credit. From a stock valuation viewpoint, Intel should be accorded a higher multiple than the median A+ credit, other factors held constant. The data in tables 2, 3 and 4 are from published financial statements gathered by Research Insight, a division of S&P.


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Bibliography:1.) http://seekingalpha.com/article/228415-why-credit-ratings-are-still-important-in-

determining-stock-valuation2.) http://library.witpress.com/pages/PaperInfo.asp?PaperID=16488 3.) http://en.wikipedia.org/wiki/Gordon_model 4.) http://en.wikipedia.org/wiki/Credit_rating 5.) http://pages.stern.nyu.edu/~adamodar/ 6.) http://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-

methods.asp7.) http://www.investopedia.com


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91711324 a literature review of concepts of credit ratings and corporate valuation

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