Chapter 23 - Credit Risk and the Value of Corporate Debt

CHAPTER 23

Credit Risk and the Value of Corporate Debt

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. The promised yield is:

$870 = $50 / (1 + IRR) + $1,050 / (1 + IRR)2

IRR = .1277, or 12.77%

To calculate the expected yield, we need the expected payoff at maturity given a
10% probability that only 40% of the promised payment will be received:

Expected payoff = .90($1,050) + .10(.40 × $1,050)

Expected payoff = $987

Now, we can calculate the IRR:

$870 = $50 / (1 + IRR) + $987 / (1+ IRR)2

IRR = .0942, or 9.42%

Est. Time: 06 – 10

2. a. Increase
b. Increase
 
An increase in either business or financial risk will increase the risk premium on the
corporate bond thereby increasing the difference between the price of the corporate bond
and the price of the Treasury bond.

Est. Time: 01 – 05

3. The option would be a put option on company’s assets with an exercise price
equal to the face value of the bond.
 
Est. Time: 01 – 05

4. Company A:

Log(relative chance of failure) = –6.445 – 1.192(−80 / 1,552.10)

+ 2.307(814 / 1,552.1) – .346(−60 / 814)
Log(relative chance of failure) = −5.1481

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Chapter 23 - Credit Risk and the Value of Corporate Debt

Relative chance of failure = e–5.1481

Relative chance of failure = .0058, or .58%

 
Company B:

Log(relative chance of failure) = –6.445 – 1.192(24 / 1,565.7)

+ 2.307(1,537.1 / 1565.7) – .346(70 / 1,537.1)
Log(relative chance of failure) = −4.2139

Relative chance of failure = e–4.2139

Relative chance of failure = .0148, or 1.48%

Est. Time: 01 – 05

5. The variables required include the expected growth in the market value of the
assets, the face value and maturity of the debt, and the variability of future asset
values (in practice, compromises need to be made if, for example, the company
has issued bonds with different maturities).
 
Est. Time: 01 – 05

6. From Table 23.4 we find that a B-rated bond has a 73.23% chance of being rated
B at year-end. The probability it will be downgraded is found as the joint
probability of receiving a CCC rating or defaulting, 4.47% + 4.70 = 9.17%.
 
Est. Time: 01 – 05

7. Both bonds are more likely to be down-rated.

 
Est. Time: 01 – 05

8. The value at risk of a loan portfolio depends on the correlation between the
outcomes of the individual loans.

Est. Time: 01 – 05

9. The value of Company A’s zero-coupon bond depends only on the ten-year
spot rate. In order to value Company B’s ten-year coupon bond, each coupon
interest payment must be discounted at the appropriate spot rate. This is not
complicated if the term structure is flat so that all spot rates are the same.
However, it can cause difficulties when long-term rates vary significantly from
short-term rates.

Est. Time: 01 – 05

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Chapter 23 - Credit Risk and the Value of Corporate Debt

10. If Company X has successfully matched the terms of its assets and liabilities,
the payment of $150 may be reasonably assured while the $50 is considerably
smaller and not due until the distant future. Company Y has a relatively large
amount due in an intermediate time frame. Thus, the risk exposure of
Company Y to future events may be greater than that for Company X.

11. Some common problems are:

a. Dishonest responses are possible (usually not a significant problem).
b. The company never learns what would have happened to rejected
applicants, nor can it revise the coefficients to allow for changing
customer behavior.
c. The credit scoring system can only be used to separate (fairly obvious)
good and bad credit risks.
d. Mechanical application may lead to social and legal problems (e.g.,
red-lining).
e. The coefficient estimation data are, of necessity, from a sample of
actual loans; in other words, the estimation process ignores data from
loan applications that have been rejected. This can lead to biases in the
credit scoring system.
f. If a company overestimates the accuracy of the credit scoring system, it
will reject too many applicants. It might do better to ignore credit scores
altogether and offer credit to everyone.

Est. Time: 06 – 10

12. Market-based risk models use comparisons between a firm’s debt level and the
market value of the firm’s assets in order to assess the likelihood of default on
the firm’s debt. The probability of default is a function of the relationship between
the amount of debt and the value of the firm’s assets. Such models require
estimates of growth in the value of the firm’s assets, variability of asset values,
and the face value and maturity of the firm’s debt. The value and the variability of
the firm’s assets are both difficult to estimate. Furthermore, a firm with a complex
capital structure that includes several classes of debt cannot be equated to a
single value to compare to the value of the firm’s assets.

Est. Time: 06 – 10

13. The spread between the promised yield and the risk-free rate is the insurance
premium. In the case of Backwoods Chemical, the promised yield is:

Promised yield = ($1,050 / $895) – 1 = .173184

The spread between the promised yield and the risk-free rate is:
Spread = .173185 – .05 = .123184

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Chapter 23 - Credit Risk and the Value of Corporate Debt

The insurance premium (paid in Year 1) is:

Insurance premium = .123184 × $895 = $110.25

Therefore, since the maturity payment is now guaranteed, the return in Year 1
becomes:

Return = $1,050 – 110.25 = $939.75

The guaranteed rate of return is:

Rate of return = ($939.75 / $895) – 1 = .0500 = 5.00%

This is equal to the one-year risk-free rate of return.

Est. Time: 06 – 10

14. The put-call parity relationship is:

Value of call + present value of exercise price = value of put + value of share

The component values can be computed as:

Value of call = value of stock

= 10 million shares × $25
= $250 million

Present value of exercise price = present value of promised payment to

bondholders
= (1.08 × $350 million) / 1.06
= $356.6 million

Value of share = asset value

= market value of debt + market value of equity
= $280 million + 250 million
= $530 million

Value of put = value of stock + present value of promised payment to

bondholders – asset value
= $250 million + 356.6 million – 530 million

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Chapter 23 - Credit Risk and the Value of Corporate Debt

= 76.6 million

Thus, the value of the option to default is $76.6 million.

15. We can consider the value of equity to be the value of a call on the firm’s assets,
with an exercise price equal to the payment due to the bondholders. Thus, the
Black-Scholes option pricing model can be applied.

For Backwoods, the exercise price is $1,090. Also:

P = $1,200
 = .45
t = 1.0
rf = 9%
d1 = .6302
d2 = .1802
N(d1) = .7357
N(d2) = .5715
Call value = $311

Thus, the value of equity is $311.

With an asset market value of $1,200, the market value of debt is:

Debt value = $1,200 – 311

Debt value = $889

Est. Time: 06 – 10

16. To measure the beta for 60% leverage, we use the following assumptions:
 V = market value of assets = $100
 rf = 0% so that:
D = face value of debt
= face value discounted at the risk-free interest rate = $60
 For the Black-Scholes model: stock price = value of assets = $100 and
exercise price = face value of debt = $60
 Standard deviation of asset value = 40%

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Chapter 23 - Credit Risk and the Value of Corporate Debt

Maturities d1 d2 N(d1) N(d2) Equity Debt Equity Debt

Value Value Beta Beta
(Call
Option
Value)

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Chapter 23 - Credit Risk and the Value of Corporate Debt

1 1.477 1.077 0.930 0.859 0.415 0.585 2.244 0.119

2 1.186 0.620 0.882 0.732 0.443 0.557 1.993 0.211
3 1.084 0.391 0.861 0.652 0.470 0.530 1.833 0.262
4 1.039 0.239 0.850 0.594 0.494 0.506 1.722 0.295
5 1.018 0.124 0.846 0.549 0.516 0.484 1.639 0.319
6 1.011 0.031 0.844 0.513 0.537 0.463 1.573 0.336
7 1.012 (0.046 0.844 0.481 0.555 0.445 1.520 0.350
)
8 1.017 (0.114 0.845 0.455 0.573 0.427 1.476 0.362
)
9 1.026 (0.174 0.847 0.431 0.589 0.411 1.439 0.371
)
10 1.036 (0.229 0.850 0.410 0.604 0.396 1.407 0.379
)
11 1.048 (0.278 0.853 0.390 0.619 0.381 1.379 0.386
)
12 1.061 (0.324 0.856 0.373 0.632 0.368 1.354 0.392
)
13 1.075 (0.367 0.859 0.357 0.645 0.355 1.332 0.397
)
14 1.090 (0.407 0.862 0.342 0.657 0.343 1.312 0.402
)
15 1.104 (0.445 0.865 0.328 0.668 0.332 1.295 0.406
)
16 1.119 (0.481 0.868 0.315 0.679 0.321 1.279 0.410
)
17 1.134 (0.515 0.872 0.303 0.690 0.310 1.264 0.414
)
18 1.150 (0.548 0.875 0.292 0.700 0.300 1.250 0.417
)
19 1.165 (0.579 0.878 0.281 0.709 0.291 1.238 0.420
)
20 1.180 (0.609 0.881 0.271 0.718 0.282 1.227 0.422
)
21 1.195 (0.638 0.884 0.262 0.727 0.273 1.216 0.425
)
22 1.210 (0.666 0.887 0.253 0.735 0.265 1.206 0.427
)
23 1.225 (0.693 0.890 0.244 0.743 0.257 1.197 0.429
)
24 1.240 (0.719 0.893 0.236 0.751 0.249 1.189 0.431
)
25 1.255 (0.745 0.895 0.228 0.758 0.242 1.181 0.433
)

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Chapter 23 - Credit Risk and the Value of Corporate Debt

Figure 23.5 for 60% leverage now looks as follows:

New bond yields are as follows:

Maturitie Debt Bond

s Value Yield, %
1 0.585 2.50%
2 0.557 3.76%
3 0.530 4.19%
4 0.506 4.35%
5 0.484 4.40%
6 0.463 4.40%
7 0.445 4.37%
8 0.427 4.34%
9 0.411 4.29%
10 0.396 4.25%
11 0.381 4.20%
12 0.368 4.16%
13 0.355 4.11%
14 0.343 4.07%

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Chapter 23 - Credit Risk and the Value of Corporate Debt

15 0.332 4.03%
16 0.321 3.99%
17 0.310 3.95%
18 0.300 3.92%
19 0.291 3.88%
20 0.282 3.85%
21 0.273 3.82%
22 0.265 3.79%
23 0.257 3.76%
24 0.249 3.73%
25 0.242 3.71%

New Figure 23.6 for 60% leverage:

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Chapter 23 - Credit Risk and the Value of Corporate Debt

This tells us that as risk rises, the spread between high-grade and low-grade corporate
bonds also rises.

Est. Time: 16 – 20

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McGraw-Hill Education.