Chapter 24 Principles PrinciplesofCorporateFinance Ninth Edition Credit Risk and the Value of Corporate Debt Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

24- 2 Topics Covered  Yields on Corporate Debt  The Option To Default  Bond Ratings and the Probability of Default  Predicting the Probability of Default  Value at Risk

24- 3 Defaulting Debt Levels $ Millions Face value of defaulting debt

24- 4 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:

24- 5 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 ValueProb 1,050.80= = = expected CF

24- 6 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:

24- 7 Yield Spreads Yield Spread, %

24- 8 Credit Default Swap Data Spread, % Credit default swaps insure holders of corporate bonds against default. Dow Jones indexes of spreads on default swaps measure the annual insurance premium.

24- 9 The Default Option Example - Circular File borrowed $50 per share, but then the firm fell on hard times and the market value of its assets fell to $30. Circular’s bond and stock prices fell to $25 and $5, respectively. Thus Circular’s market-value balance sheet is: Circular File Company (market values) Asset value$30$25Bonds $ 5Stock $30$30Firm value Circular File Company (market values) Asset value$30$25Bonds=Asset value – call value $ 5Stock=value of a call $30$30Firm value=Asset value

The Default Option Example (continued) - The value of Circular’s common stock is the value of a call option on the firm’s assets with an exercise price of $50.

Interest Rates, Risk, and Maturity Difference between promised yield on bond and risk-free rate, percent Maturity, years

Key to Bond Ratings 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.

Bond Ratings and Financial Ratios Three years of median ratio data by bond rating (2002– 2004).

Bond Ratings and Default Default rates of corporate bonds by S&P’s rating at time of issue

Predicting Default A comparison of financial statements from firms that have gone bankrupt with those firms that have not gone bankrupt reveals information valuable to the lending decision. Financial ratios of 544 failing and non-failing firms.

Credit Analysis Predicting Default - William Beaver, Maureen McNichols, and Jung-Wu Rhie, studied defaulting and non-defaulting firms and concluded the chance of failing during the next year relative to the chance of not failing was best estimated by the following equation:

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.

Asset Value and Default Value, $ millions The market value of WorldCom assets, as default approached Default date

Default Probability Probability of default over next year Moody’s estimate of WorldCom’s probability of default Default date

Value at Risk (VaR) Value at Risk = VaR  Newer term  Attempts to measure risk  Risk defined as potential loss  Limited use to risk managers Factors  Asset value  Daily Volatility  Days  Confidence interval

Value at Risk (VaR) Standard Measurements  10 days  99% confidence interval  VaR

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.

Value at Risk (VaR) Example  You 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?

Ratings Changes

Yields and Ratings Alcan bond price changes, relative to changes in the bond rating

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