chapter 23 principles principlesofcorporatefinance tenth edition credit risk and the value of...
TRANSCRIPT
Chapter 23 PrinciplesPrinciples
ofof
CorporateCorporate
FinanceFinance
Tenth Edition
Credit Risk and the Value of
Corporate Debt
Slides by
Matthew Will
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw Hill/Irwin
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Topics Covered
Yields on Corporate DebtThe Option To DefaultBond Ratings and the Probability of DefaultPredicting the Probability of DefaultValue at Risk
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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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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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Yield Spreads
Yie
ld S
prea
d, %
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Credit Default Swap DataSp
read
, %Credit default swaps insure holders of corporate bonds against default. Dow Jones indexes of spreads on default swaps measure the annual insurance premium.
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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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Bond Ratings and Financial Ratios
Ratio AAA AA A BBB BB B CCC
EBIT interest cover * 23.8 19.5 8 4.7 2.5 1.2 0.4return on capital % 27.6 27 17.5 13.4 11.3 8.7 3.2Total debt/capital % 22.9 28.3 37.5 42.5 53.7 75.9 113.5
* Earnings before interst and tax divided by interest
Three years of median ratio data by bond rating (2002– 2004).
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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 0.6AA 0 0.3 0.9
A 0 0.6 1.9BBB 0.3 3.1 6.6BB 1.2 12.7 24B 5.9 30.5 44.8
CCC 30.4 56 67.7
Percentage Defaulting Within
Default rates of corporate bonds 1981-2005 by S&P’s rating at time of issue
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Credit Analysis
Credit analysis is only worth while if the expected savings exceed the cost.– Don’t undertake a full credit analysis unless the
order is big enough to justify it.– Undertake a full credit analysis for the doubtful
orders only.
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Asset Value and Default
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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Value at Risk (VaR)
Value at Risk = VaR
Newer termAttempts to measure riskRisk defined as potential lossLimited use to risk managers
FactorsAsset valueDaily VolatilityDays Confidence interval
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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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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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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