Principles of

Chapter 11 Corporate Finance

Tenth Edition

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.

11:2

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
 11:3

Defaulting Debt Levels

Face value of defaulting debt

450

400
$ Millions

350

300

250

200

150

100

50

0
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
11:4

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:
 11:5

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 Value Prob

1,050 .80 = 840.00
500 .20 = 100.00 .

940 940.00 = expected

Value
CF   $895
1.05
1050
YTM   1  17.3%
895

11:6

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:

940
Value   $870.00
1.08
1050
YTM   1  20.7%
870.00
 11:7

Yield Spreads

16

Aaa
14
Yield Spread,

Baa
12
High Yield
10

6
%

0
1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008
11:8

Credit Default Swap Data

Credit default swaps insure the holders of corporate bonds against default. This
figure shows the cost of default swaps on the 10-year senior debt of four
companies. Source: Datastream
700

600

Boeing
500
Spread

GE

Disney
Basis points

400
Dow Chemical

300

200

100

0
01-05
03-05
05-05
07-05
09-05
11-05
01-06
03-06
05-06
07-06
09-06
11-06
01-07
03-07
05-07
07-07
09-07
11-07
01-08
03-08
05-08
07-08
09-08
11-08
01-09
03-09
05-09
07-09
 11:9

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

11:10

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.
 11:11

Interest Rates, Risk, and Maturity

5
Leverage = 100%
Leverage = 60%
4 Leverage = 40%
Leverage = 20%
Difference 3
between
promised
yield on bond 2
and risk-free
rate, percent
1

11

13

15

17

19

21

23

25
1

Maturity,
years

11:12

Key to Bond Ratings

Moody's S&P's & Fitch

Investment Grade
Aaa AAA
Aa AA
A A
Baa BBB
Junk Bonds The highest quality
Ba BB bonds are rated triple-A.
B B Investment grade bonds
Caa CCC
have to be equivalent of
Ca CC
Baa or higher. Bonds
C C
that don’t make this cut
are called “high-yield” or
“junk” bonds.
 Bond Ratings and Financial 11:13

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

Ratio AAA AA A BBB BB B CCC

EBIT interest cover * 23.8 19.5 8 4.7 2.5 1.2 0.4
return on capital % 27.6 27 17.5 13.4 11.3 8.7 3.2
Total debt/capital % 22.9 28.3 37.5 42.5 53.7 75.9 113.5

* Earnings before interst and tax divided by interest

11:14

Bond Ratings and Default

Default rates of corporate bonds 1981-2008
by S&P’s rating at time of issue

60
Cumulative default rate, %

50 AAA
AA
40
A
30 BBB
BB
20
B
10 CCC

0
1 2 3 4 5 6 7 8 9 10
Years after issue
 11:15

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.

11:16

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:

Log (relative chance of failure)

 6.445  1.192 ROA  2.307liabilities / assets  .346 EBITDA / liabilities

Relative chacne of failure  e L

 11:17

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.

11:18

Asset Value and Default

The market value of Six Flags assets, as default
approached
 11:19

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

11:20

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
 11:21

Value at Risk (VaR)

Standard Measurements
 10 days
 10   day  10

 99% confidence interval

99%    2.33

 VaR

VaR  ( 10  2.33)  asset value 

11:22

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.
 10  .02  10
 6.32%

99%( )  .0632  2.33

 14.74%

VaR  .1473 10,000,000

 $1,473,621
 11:23

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
VaRIBM  $1,473,621
portfolio?
VaRAT &T  $368,405
DiversificationBenefit
VaRAT &T  IBM  $1,842,026  $90,647

VaRPortfolio  $1,751,379

11:24

Ratings Changes

Rating at end of year

Start of
year, % AAA AA A BBB BB B CCC Default Default
AAA 88.39 7.63 0.53 0.06 0.08 0.03 0.06 0 3.23
AA 0.58 87.02 7.79 0.54 0.06 0.09 0.03 0.03 3.86
A 0.04 2.04 87.19 5.35 0.4 0.16 0.03 0.08 4.72
BBB 0.01 0.15 3.87 84.28 4 0.69 0.16 0.24 6.6
BB 0.02 0.05 0.19 5.3 75.74 7.22 0.8 0.99 9.68
B 0 0.05 0.15 0.26 5.68 73.02 4.34 4.51 12
CCC 0 0 0.23 0.34 0.97 11.84 46.96 25.67 14
 11:25

Web Resources
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www.standardandpoors.com
www.bondsonline.com
www.mkmv.com
www.riskmetrics.com