1. Credit Risk and the Value of Corporate Debt
Principles of
Corporate Finance
Tenth Edition
Chapter 23
Credit Risk and the Value of Corporate Debt
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

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 2 2 2 2 3 2

3. Defaulting Debt Levels
Face value of defaulting debt
$ Millions

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:

5. Valuing Risky Bonds Example A: Bond Value Prob 1,050 .80 = 840.00
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, = =
= expected CF

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:

7. Yield Spreads
Yield Spread, %

8. Credit Default Swap Data
Spread

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 $25 Bonds
$ 5 Stock
$30 $30 Firm value
Circular File Company (market values)
Asset value $30 $25 Bonds=Asset value – call value
$ 5 Stock=value of a call
$30 $30 Firm value=Asset value

10. 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.

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

12. 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.

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

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

15. 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.

16. 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: 12

17. 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. 16

18. Asset Value and Default
The market value of Six Flags assets, as default approached

19. Moody’s estimate of Six Flags probability of default
Default Probability
Moody’s estimate of Six Flags probability of default

20. 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

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

22. 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.

23. 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?

24. Ratings Changes

25. Web Resources Click to access web sites Internet connection required