2. 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

3. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-3 What 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

4. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-4 Default 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

5. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-5 The 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.

6. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-6 Ratio Analysis for Default Evaluation Steps: 1.Reformulate financial statements 2.Calculate ratios

7. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-7 Reformulating 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.

8. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-8 Off-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 leases Agreements and commitments: third-party agreements through-put agreements take-or-pay agreements repurchase agreements sales of receivables with recourse Special purpose entities not consolidated Unfunded pension liabilities not booked Guarantees of third-party or related-party debt Positions in derivatives off balance sheet

9. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-9 Reformulated Income Statements and Cash Flow Statements 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

10. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-10 Ratio Analysis: Short-Term Liquidity Ratios Liquidity Stock Measures

11. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-11 Ratio Analysis: Short-Term Liquidity Ratios Liquidity Flow Measures

12. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-12 Ratio Analysis: Long-term Solvency Ratios Solvency Stock Measures

13. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-13 Ratio Analysis: Long-term Solvency Ratios Solvency Flow Measures

14. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-14 Ratio 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

15. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-15 Forecasting 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

16. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-16 Forecasting 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

17. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-17 Multiple Discriminate Analysis (Z-scoring) Original Altman Model:

18. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-18 Logit Scoring Model Original Ohlson Model:

19. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-19 Credit 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

20. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-20 Full Information Forecasting: Using Pro Forma Analysis for Default Forecasting PPE Inc.

21. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-21 Using Pro Forma Analysis for Default Forecasting PPE Inc.

22. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-22 Default Points Default occurs when cash available for debt service is less than the debt service requirement.

23. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-23 Value-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

24. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-24 Value-at-Risk Profile

25. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 19-25 Liquidity 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