Ch6 - Fundamental Credit Analysis

Question 1

What is Fundamental Credit Analysis?

Answer 1

Credit analysis of the company that revolves around:

• Its political, economic, regulatory, and competitive environment
• Its management, products and operations
• Its financial status

Question 2

Discuss the incentives of the creditors and shareholders that give rise to the fundamental agency conflict between the two groups

Answer 2

• Managers, working on behalf of shareholders, are making decisions behind the scenes. These decisions partly influence the corporations credit risk profile.
• This human element is very important in determining credit risk profile
• Creditors have an agency conflict with shareholders
• Creditors have no control over decisions of managers, or over the shareholders they represent. These two groups have different incentives and their risk/return profiles are distinctive

Question 3

The Agency Relationship

Answer 3

• Managers make decisions on behalf of SHs who appoint them, and these decisions affect creditors
• Thus, SHs can be considered agents of the creditors
• SHs make decisions surrounding R/D investment, product development capital structure etc, that affect the corporation’s profitability and risk profile. They affect the value of debt and therefore affect creditors directly.
• SHs will make decisions in their own interests, whether they are aligned with the interests of creditors or not

Question 4

Misalignment of Incentives

Answer 4

• SHs and creditors share neither losses nor gains in a proportionate way.
• When losses occur, SHs pay first, with losses eating into retained earnings in capital
• Creditors, in contrast, don’t experience losses until the SH’s equity is exhausted
• When gains are made, SHs get all the upside, with creditors receiving a prenegotiated capped amount

Question 5

What influences Shareholders’ incentives?

Answer 5

1. SHs are highly incentivised to take risks since this has the potential for large gains
2. SHs are in a first-loss position, so any new capital they inject into a company is prone to being lost.
   - Creditors have far less to gain from risk taking and are more prone to losses.
   - The creditor is most interested in being repaid. There is no upside, only downside, thus a preference for the status quo (no volatility). New strategies, M/A activity, alterations to cap structure are all causes for alarm, and therefore many lending covenants prevent such

Question 6

The Merton Model

Answer 6

• Owning stock in a company is equivalent to a call option and selling a put option in the company’s assets. with the strike price being the price of debt.
• At maturity, the value of assets will either be greater than, less than or equal to the debt. If strike price = price of debt, then if assets are worth more than the debt, the debt can be paid off.
• Yet if the value of the company’s assets is below the value of debt at maturity, the call option is worthless and expires without being exercised (SHs walk away, leaving creditors with debt that cannot be extinguished with the company’s assets)

Question 7

The Merton Model (2)

Answer 7

SHs’ incentives: unless their option is in-the-money, they will not exercise it and walk away from their obligations to creditors. Because SHs enjoy limited liabilities, their can stick their losses on creditors
-Default simply arises from the value of the company’s assets falling short of the value of the debt at maturity. Credit risk, therefore, is a function of the likelihood that debt will exceed assets at maturity.