Lesson 4

Question 1

why is EV distribution relevant?

Answer 1

because it is the main determinant of bankruptcy risk and thus the consequential cost of debt (kd)

Question 2

why is there a relationship between cash flow risk and dispersion of possible enterprise value?

Answer 2

because each year projected cashflows are not certain, and EV is a function of the sum of DCFs

Question 3

what are the two components of EV?

Answer 3

risk free component: value that can be attributed to stable, predictable, and low-risk assets or cash flows

risky component: part of EV that fluctuates based on market conditions, business performance, or other uncertain factors

Question 4

why should a creditworthiness evaluation model be consistent with option evaluation theories?

Answer 4

because a company’s liabilities represent rights to the company’s assets, which often take the form of options and can be priced

Question 5

what is the implication of using market values for credit risk assessment?

Answer 5

it allows to provide a realistic description of the relationship between the characteristics of the company (its value) and the probability of default on its debts.

if the company is listed, the evaluation has been already performed by the market, and is reflected in the market value of the company. If the company is not listed than it is necessary to determine its market value based on future cash flows.

Question 6

in the capital structure, who has the lowest reimbursement priority? what are the implications?

Answer 6

equity.

as a company’s future operating prospects start to look better or worse, EV changes and the share price will be the FIRST to reflect the change in prospects

Question 7

in conditions of failure, is it necessary that the company has sufficient liquidity to pay interest on the portion of debt falling due? Why?

Answer 7

no.

what is relevant is whether the market value of the company’s net assets (EV) is adequate compared to the level of debt

if the company’s assets have sufficient market value, the company can raise the necessary liquidity:
1. selling part of its assets
2. issuing equity
3. issuing debt

concluding, a company’s ability to pay back (in the future, when due) its debt depends on its future market value and not on the (instantaneous) value of its future cash

Question 8

2 definitions of bankruptcy (law interpretation)

Answer 8

1. default with respect to liquidity (no liquidity to pay interest or repay capital)
2. default at value (EV < nominal value of fin. D)

Question 9

3 necessary conditions for failure to occur (simultaneamente)

Answer 9

1. contractual condition (company is obliged to repay the debt)
2. liquidity condition (company does not have necessary liquidity to repay the debt)
3. value condition (no possibility of raising further financing that guarantees the liquidity necessary to repay the debts)

Question 10

how can the logic of “liquidity” bankruptcy lead to wrong conclusions?

Answer 10

1. company has made investments with high NPV > in the future it will generate value (EV and GW) > however, it is in a temporary liquidity crisis > at the same time, in the future it will generate value and EV grows compared to nominal debt > better prospective financial situation, worse current liquidity situation. Conclusion: in a RATIONAL and EFFICIENT market, there will always be an investor (E) or financier (D) willing to provide additional capital to overcome TEMPORARY lack of liquidity
2. company has subscribed long term debt which will liquidate its operating assets > this condition CANCELS future operating CFs, but gives enough LIQUIDITY to service interest and principal payments.
   Conclusion: IF liquidity raised < value of debt, the company is “virtually bankrupts” even if it does not have CURRENT financial imbalances or lack of liquidity

Question 11

why is the value default condition that EV < D, and NOT ONLY the MATURING debt?

Answer 11

bankrupcty occurs when a company does not have sufficient liquidity AND does not have sufficient “reserves of value”

imagine a company with
- EV of 800
- Debt of 1000
- Maturing debt (debt to be repaid) of 150

we can hypothesize two cases:
a) the firm has sufficient liquidity: it repays debt but is still “virtually bankrupt”, as after repayment EV < D (650 < 850). At the following payment…

b) the company does not have sufficient liquidity to repay the debt. Selling part of its assets would just delay bankruptcy, it would only make the company more liquid but decrease its value. In order to raise sufficient liquidity it should:
1) increase capital: additional equity would just be used to satisfy the value of UNCOVERED debts. Debtholders would be happy and shareholders would be stupid.

2) “replace” debt: the creditor knows that part of the debt will not be returned. The loan has negative NPV and the creditor would just be participating in the failure.

Question 12

How do you determine expected loss in case of bankruptcy?

Answer 12

once the distribution of the possible enterprise values at debt maturity has been determined, the company decides the level of nominal debt it assumes (consider graph on slide 10)

EL = loss for each EV below D_nom * respective probabilities

Question 13

what determines minimum EV?

Answer 13

risk free debt, where K_d = i_riskfree

Question 14

what is the equilibrium condition of debt?

Answer 14

expected EV at time of repayment is a t least equal to the value of TOTAL debt

Question 15

what is a company’s probability of default?

Answer 15

the probability that the expected EV realized in year “n” is lower than the value of the debt.

! in this case, the company would not be able to refinance the debt and collect necessary liquidity, ending up in actual default.

!! default is a phenomenon that OCCURS in the presence of a liquidity imbalance but ARISES from a value imbalance

Question 16

determining analytically the cost of debt capital

Answer 16

if the probability of loss by the debtholder is zero, then the debt is risk free and E[payoff] = D_nom holds

if there is a probability of loss for the debtholder, there is the need to identify an equilibrium interest rate that allows the lender to recover in advance the expected value of the loss at time of repayment

! E[payoff] = D_nom still has to hold

if risk premium =
(E[loss] / Dnom) * (risk-free)/[(1+riskfree)^n -1]

K_d = i_riskfree + risk premium

!!!!!!!!!!!also the formula with BC is possible!!!!!!!

risk premium is a function of:
1. expected loss at maturity

2. maturity: double effect (more time > more risk, but more time > justified higher rate to “recover”)
3. risk free rate: high rates reduce the discounted value of LOSS, and, all else equal, high risk free rate LOWERS credit risk premium

Question 17

exercise slide 18

Question 18

what are bankruptcy costs? what is their effect?

Answer 18

inability of a company to meet its obligations towards lenders by way of credit does not have the sole effect of breaking down the expected cash flow among shareholders and debtholders. Bankruptcy generates a series of costs that lead to a reduction in EV in the event of liquidation:

• additional costs
• reduction of the economic value of assets (from going concern to bankruptcy state)

Question 19

what is different in the idea of “value” in a going concern with respect to a bankruptcy liquidation state?

Answer 19

going concern: the value of a company is represented by the DCFs

liquidation state: value of the transfer of a company’s assets to clearance prices

! for this reason, one could say that BC = E[EV_going concern] - Liquidation value

Question 20

Bankruptcy costs to the firm (direct and indirect) and costs to claimholders

Answer 20

costs to the firm
DIRECT: advisors, pre-bankruptcy costs, internal structure costs

INDIRECT: debtors do not pay liabilities, capital losses

costs to claimholders: monitoring, direct and indirect liquidation costs

Question 21

what is a reasonable range of bankruptcy costs size as a % of EV?

Answer 21

total firm costs: 10 - 15%
total claimholders costs: +- 4%

Question 22

what happens to expected value distribution when bankruptcy costs arise? (slide 25)

Answer 22

short answer:
- increase in K_d
- payoffD = D_mkt = D_nom still has to hold
- reduction in total payoff to shareholders and debtholders
- reduction in the value of equity equal to the expected value of the BC

• for any vale of EV below the nominal debt, payoff to lenders becomes: EV - BC
• the distribution of payoffs becomes discontinuous
• EV is reduced by an amount equal to E[BC]
  where E[BC] = BC*PD
• !!! debtholders, forced to bear BC, adjust the equilibrium interest rate charged in order to maintain E[Payoff] = Dnom&raquo_space;»> consequently, the of expected value of the payoff is passed on to ** shareholders** through the risk premium and the cost of debt capital!!!
• the reduction in expected value of equity is equal to the value of expected failure costs

Question 23

does the risk premium in the case of the existence of bankruptcy costs increase in an amount proportional to the expected value of these costs compared to the nominal value of debt?

Answer 23

yes

Question 24

consider the cost of debt capital (y axis) and financial leverage (x axis) graph. What do you notice looking at K_d with and without bankruptcy costs?

Answer 24

the point of default is identical, but the slope is different. k_d with BC is steeper because for the same probability of default there are higher losses for debtholders that must be recovered through higher financial interests

Question 25

why is market value of debt important? (2 reasons)

Answer 25

1. defines equity: equity is the difference between what the company generates from an asset side point of view (EV) and the value to be repaid to debtholders
2. defines equity risk and cost of capital: it determines the measure of financial leverage

Question 26

what are the 2 components of “market value of debt”? how are they calculated?

Answer 26

1. bank debt: value is determined through an implicit process
2. bonds: debt traded on the market and valued by the market

Question 27

how would you value a bond?
what are the 3 fundamental variables that influence interest rate applicable to the valuation of bonds?

Answer 27

A) DCF
the cash flows are fixed, so the value is inversely related to the interest rate appropriate to the bond’s degree of risk

B)
1. short term risk free rate
2. maturity premium: long term - short term risk free interest rates
3. bond-specific default risk

! since interest rates are quoted annually, make sure you consider periodic payments

Question 28

simplified formula for bond prices, using the bond’s nominal value

Answer 28

slide 38

Question 29

what is the YTM of a bond?

Answer 29

the **cost of capital **implicitly used by the market to discount the monetary flows associated with the bond

Question 30

bond valuation exercise

Answer 30

slide 40

Question 31

Interest coverage ratio

how do you interpret the result?

Answer 31

A) interest coverage ratio

EBITDA / net financial charges

the ratio indicated to what extent the resources generated by core management activity (EBITDA) are able to cover the payment of financial charges

B) this represents a “steady state” condition and is i_cov ratio remains higher than 1 even if the company is not able to repay the NOMINAL value of debt

low risk of fin debt if > 2.5
1 < medium-high risk of fin debt < 2.5
very high risk of fin debt if < 1

Question 32

what would you use as risk free rate?

Answer 32

EURIRS or EURIBOR

Question 33

the three main determinants of “different types of debt”

Answer 33

1. duration
2. seniority
3. guarantees

Question 34

main categories of debt based on duration (from shorter to longer)

Answer 34

1.** self liquidating credit** (revolving), a bank advances commercial credit and is reimbursed trough collection

2. credit at sight: buyer’s bank guarantees payment as soon as the seller presents required document (for example a bill of lading)
3. ST debt, to be repaid within a YEAR (CIVIL law) or 18 months (FINANCIAL criterion)
4. medium term, more than 18 months but less than 5 years
5. LT loans, more than 5 years

!!! USUALLY medium and Long Term loans are subject to periodic forms of amortization, and are OFTEN backed by real guarantees (pledge or mortgage)

Question 35

different categories of debt based on seniority

Answer 35

1. senior debt
2. unsecured debt
3. subordinated / junior
4. mezzanine

Question 36

different categories of debt based on guarantees

Answer 36

1. unsecured credit
2. debt secured by internal guarantees
3. debt supported by external guarantees (surety) or real guarantees on assets (for example by shareholders)

Question 37

what is the difference in effect on EV between internal and external guarantees?

Answer 37

internal guarantees “order” the debt with respect to repayment priority, **external guarantees don’t UNLESS** DIRECTED TO SPECIFIC CREDITORS

the existence of external guarantees does not “disadvantage” other creditors

EV with guarantee > EV without