Case 12: Fruit of the Loom

Bond Ratings

Questions

1. Define what is meant by "a Pecking Order."

Pecking Order refers to the chain of priority that stakeholders in a company have on the
company's assets. The order is as follows: senior debenture holders, junior debenture holders,
preferred stockholders, and then common stockholders. This order represents which investor
group has first through last claim when it comes to receiving coupon or dividend payments and
even in the event of collecting in liquidation.

2. Why is it, specifically, that the 8.875% bond received a downgrading from BB- to B?

The 8.875% bonds received a downgrade because it effectively slipped down in the Pecking
Order. This is important because these bondholders cannot receive coupon payments or the
return of principle in the event of maturity or default until all of the other debt holders receive
their money first. This lowers the probability that these bondholders will receive their promised
payments which effectively increases the risk of the bonds. Higher risk translates into a lower
bond rating.

3. Should the stock price react to this bond's down rating? Why or why not?

It is unlikely that the stock price will be affected. Moreover, even if the overall company were to
be downgraded, financial studies have shown that rating companies take time to make changes to
corporate bond ratings. Therefore, by the time a rating change has been made, the change was
already anticipated by the stock market, and therefore, its effect is already imbedded into the
stock's price.

4. Why is it that firms in different industries can have the same capital structure and the
same Earnings Per Share (EPS), but still have a different bond rating?

Capital structure and level of Earnings per Share (EPS) will definitely affect a corporation's bond
ratings. However, what the question did not include is the volatility in EPS. Firms with more
stable earnings, like utility companies, can afford to take on more debt than firms in a less stable
industry, like the technology sector, and still have the same bond rating. It is all a function of the
probability of default.