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Financial Analysis > week 11 > Flashcards

week 11 Flashcards

1
Q

Why Do Firms Use Debt?

A
  1. Interest on debt is tax-deductible
  2. Help existing shareholders maintain control of company
  3. Increase earnings per share (if investment is successful)
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2
Q

The Credit Analysis Process in Private Debt Markets

1.

A
  1. Consider the nature and purpose of the loan:

– This helps with structuring the terms and duration of the loan, along with the rationale for borrowing.

– The size of the loan must be set.

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3
Q

The Credit Analysis Process in Private Debt Markets

2.

A
  1. Consider the type of loan and available security:

– Numerous types of loans are available from open lines of credit to lease financing.

– The type and amount of security needed to collateralise a loan must be established.

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4
Q

The Credit Analysis Process in Private Debt Markets

3.

A

3.Analyse borrower’s current performance and position:

– Comprehensive analysis of business strategy, accounting and financial aspects of the firm.

  • Ratio analysis is useful, particularly ratios addressing the ability to make loan payments.
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5
Q

The Credit Analysis Process in Private Debt Markets

4.

A
  1. Use forecasts to assess payment prospects
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6
Q

The Credit Analysis Process in Private Debt Markets

  1. Use forecasts to assess payment prospects:

who are the forecasts made by

A

The forecasts are typically made by management and should be subjected to significant scrutiny.

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7
Q

The Credit Analysis Process in Private Debt Markets

  1. Use forecasts to assess payment prospects:

What does this involve

A

Conduct extensive sensitivity analysis

  • How bad does growth / margins have to be before the borrower defaults?
  • For larger firms, analyst forecasts of key variables may be available, and can be used in place of / alongside management forecasts.
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8
Q

The Credit Analysis Process in Private Debt Markets

5.

A
  1. Assemble loan structure and debt covenants (if loan is to be offered).
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9
Q

The Credit Analysis Process in Private Debt Markets

  1. Assemble loan structure and debt convenants

describe

A

Loan covenants specify mutual expectations of the borrower and lender

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10
Q

The Credit Analysis Process in Private Debt Markets

Key covenant terms include:

A

the borrower promising to maintaining specific financial conditions.

• The borrower promising not to take certain actions (e.g. taking out additional secured loans)

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11
Q

The Credit Analysis Process in Private Debt Markets

the final step is to

A

determine whether to grant a loan (or renew a loan), and if the loan is granted what should the terms of the loan be:

– Interest rate (riskier borrower = higher rate)

– Debt covenants to protect lender
– Security (assets pledged to secure loan)

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12
Q

Creditors Emphasise Downside Risk

what does this mean

A

Potential creditors place greater emphasis on the likelihood of poor financial performance

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13
Q

Creditors Emphasise Downside Risk

A

– ‘Upside’ for a creditor is fixed – the best return they can get is the timely repayment of their principal and contractually agreed interest

– No occasional huge returns to compensate for losses incurred if debtors default on their repayments

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14
Q

Creditors Emphasise Downside Risk

A

– ‘Upside’ for a creditor is fixed – the best return they can get is the timely repayment of their principal and contractually agreed interest

– No occasional huge returns to compensate for losses incurred if debtors default on their repayments

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15
Q

Equity v Credit Investment – Considerations Prior to Investment Decision

• Potential equity investors are interested in

A

Potential equity investors are interested in understanding the full distribution of (expected) future returns

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16
Q

Equity v Credit Investment – Considerations Prior to Investment Decision

• Potential equity investors are interested in understanding the full distribution of (expected) future returns

These returns are bounded at

A

These returns are bounded at -100% (you can lose your whole investment, but no more) with no limit to possible positive returns

– Equity holder could lose their whole investment, but could also make 200000%+ profit

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17
Q

After a debt agreement is in place,

A

the incentives facing managers (as representatives of equity holders) may change

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18
Q

Why do the managers incentives change after a debt agreement is in place?

A

– Some proportion of the down-side risk of firm’s future investment decisions is transferred from equity holders to debt holders

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19
Q

Why do the managers incentives change after a debt agreement is in place?

Some proportion of the down-side risk of firm’s future investment decisions is transferred from equity holders to debt holders

give an example

A

If a $200m project is financed 100% by equity, equity holders bear all of the risk of success/ failure

– If same project is financed 90% by Debt:

  • If project is successful equity holders make big +ve return; Debtholders get their promised principal and interest
  • If project fails, most of the losses borne by debtholders
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20
Q

Debt Covenants have two main purposes:

Firstly

A

Act as an ‘early warning’ system, allowing the creditor to take steps to protect their interests as the outstanding debt becomes riskier

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21
Q

Debt Covenants have two main purposes:

Secondly

A

Control the risk-taking behaviour of the borrower by aligning borrower incentives with that of the lender

• Mitigate the ‘agency costs of debt’,

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22
Q

Agency Costs of Debt

• An ‘agency’ relationship exists where

A

the lender (owner of an asset) grants decision making authority over that asset to the borrower (equity holders of the borrowing firm; agent)

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23
Q

Agency Costs of Debt

A

Borrower’s decisions affect the return to the Lender

– Borrower may try to transfer wealth to equity holders, at the expense of debt holders.

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24
Q

What is the Lender Worried About?

• Debtholder-Shareholder relationships create

A

Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:

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25
Q

What is the Lender Worried About?

• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:

A
  1. excessive dividend payouts
  2. Under investment
  3. asset substitution
  4. claim dilution
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26
Q

What is the Lender Worried About?

• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:

1. excessive dividend payouts

A

reduces owner’s equity, increasing chance of insolvency

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27
Q

What is the Lender Worried About?

• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:

1. Under investment

A

particularly at times of crisis – bias against low risk positive NPV project)

• When borrowing firm is in distress, most of the benefit from accepting positive NPV low risk projects accrues to the lender (reduces the likely ‘loss on default’ but unlikely to save the borrowing firm completely

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28
Q

What is the Lender Worried About?

• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:

3. Asset substitution

A

changing the firm’s overall asset structure after acquiring debt – from lower risk to higher risk

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29
Q

What is the Lender Worried About?

• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:

4. claim dilution

A

aking on extra debt which may dilute the existing creditors’ claim on the firm in liquidation

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30
Q

So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship

A

Include covenants in loan agreement

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31
Q

So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship

covenant in loan agreement

MINIMUM NET WORTH

A

(Minimum Equity)

  • Provides equity cushion to limit chance of bankruptcy
  • Allows the firm to work out the best way to provide that equity cushion (incr. Profits, restricting divs, issueing new equity etc)
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32
Q

So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship

covenant in loan agreement

Minimum ‘Coverage’ Ratios

A

ratio of EBIT / interest expense

or EBIT / Estimated Repayments on Loan

Cash flow-based coverage also possible

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33
Q

So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship

Debt covenant

Maximum Leverage

A

Total Liabilities / Equity or

Total Liabilities / Net Tangible Assets

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34
Q

So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship

Debt covenant

Which covenant forces borrower to maintain liquidity

A

Minimum Net Working Capital or Current Ratio:

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35
Q

So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship

Debt covenant

Which covenant directly limits growth funded externally

A

Maximum Capital Expenditure / EBITDA

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36
Q

So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship

Debt covenant

Negative Pledges

A

Promises to refrain from behaviour such as issuing new debt, assigning security interests in existing assets etc

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37
Q

Breach of a debt covenant allows the lender to:

A
  1. Renegotiate the terms of the loan (most common outcome)
  2. Waive the breach
  3. Accelerate repayments
    • Call in the loan in its entirety
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38
Q

The types of credit sought/granted are related to:

A
  1. term to maturity / duration of the assets acquired / already owned by the borrower
  2. Riskiness of firm’s cash flows
  3. Collateral value of assets available to secure the debt
  4. How much debt the firm has already incurred
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39
Q

Bank loans

Terms typically

A

0-15 years

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40
Q

Bank loans

Different repayment patterns, including

A

– Standard amortisation – constant annual payment, early payments largely interest, later payments largely reflect principal reduction

– Interest-only period

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41
Q

Bank loans

Interest rates

A

Fixed or Variable Interest Rates

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42
Q

Bank loans

Security

A

May be secured by claim over assets

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43
Q

Public Debt

A

Firms may issue bonds/debentures to the market

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44
Q

Public Debt

Bonds and debentures

A

Promises to pay a (usually) fixed periodic interest payment (‘the coupon’) and the face value of the bond upon maturity

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45
Q

Public Debt

Secondary market

A

Initial investor in the bond can sell the bond to other investor

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46
Q

Revolving Credit Facilities

A

Revolving Credit Facilities allow the borrower access to a prescribed amount of credit for a period of time +

the borrower can choose how much of the available funds to actually draw down at any time

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47
Q

Revolving Credit Facilities

A

Revolving Credit Facilities allow the borrower access to a prescribed amount of credit for a period of time +

the borrower can choose how much of the available funds to actually draw down at any time

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48
Q

Some companies (such as Michael Hill) have a revolving Bank Bill facility, under which their

A

Some companies (such as Michael Hill) have a revolving Bank Bill facility, under which their bank provides the promised finance by purchasing short-term Bills of Exchange issued by MH

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49
Q

Revolving credit facility

what happens when one of the ST debt instruments reaches maturity

A

When one of these ST debt instruments reaches maturity, the borrowing company has the right to issue another ST debt instrument to replace it

– The new debt instrument is also issued to the bank providing the Bill Facility

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50
Q

Revolving credit facilities

Commercial Bank Bill facilities may

A

allow the borrower to ‘lock in’ a fixed interest rate in advance, for periods of up to 5 years:

– i.e. The price at which the new Bills are issued to the bank can be ‘locked in’

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51
Q

Revolving bank bill facility

1 Jan 2014: Michael Hill issues a $100 180-day Bill

– Bank pays MH $95 for the Bill

A

– Bank pays MH $95 for the Bill ($5 difference = implicit interest)

• The principal on the debt = $95

– Bank can sell this Bill to other investors, but Bank accepts liability for the $100 owing at maturity (hence the term ‘bank accepted bill’ or ‘bank bill’)

• $100 owing includes $95 principal and $5 accrued interest payable

52
Q

Revolving bank bill facility

1 Jan 2014: Michael Hill issues a $100 180-day Bill

– Bank pays MH $95 for the Bill

30 June Michael Hill is due to pay bank $100. Normally:

A

– MH issues new $100 180 day Note (described as a ‘rollover’)

– Bank ‘pays’ MH $95 for new Note

– MH ‘pays’ Bank $100 to settle obligation from old Note, using $95 from new Note + $5 other cash

53
Q

Revolving bank bill facility

1 Jan 2014: Michael Hill issues a $100 180-day Bill

– Bank pays MH $95 for the Bill

30 June Michael Hill is due to pay bank $100.

If MH chooses,

A

it could simply pay the $100 owing and thereby reduce their debt

– This payment would be comprised of $5 interest and a $95 principal reduction

54
Q

The continuation of the revolving facility is

A

subject to annual reviews of the creditworthiness of the borrower.

55
Q

While ever MH’s debt financing requirements are

A

stable or increasing (in raw $ value) all of MH’s cash payments to the bank will be for interest (no principal reduction).

– All net cash payments made by MH will be tax-deductible in this case

56
Q

liabilities owing on a revolving bill facility is

A

$62.1m

57
Q

what is net debt owing at the end of 2006 fin year

where there is $4m of cash:

A

about $58m, arising from liabilities owing on a revolving bill facility ($62.1m) and about $4m of cash:

58
Q

MH have agreed access to credit?

A

MH have agreed access to $77,640m of credit from ANZ bank ($3,165m in overdraft; $74,475m in Bill facility)

59
Q

are they using bank overdraft facility?

A

They are not using the overdraft at 30/6/2006

60
Q

what is their outstanding bills payable?

A

They have outstanding Bills Payable of $62,134

61
Q

how can we assess Michael Hill’s present creditworthiness

A

assess the ease with which MH is expected to be able to meet its

existing debt obligations, via:

– Standard Ratio Analysis (current Debt / Equity, Interest Coverage Ratio etc)

– Cash Flow Coverage Ratio and forward projections of this ratio and Free Cash Flow to the Firm

62
Q

Standard Ratio Analysis tells us about the present situation

What do we try to find

A

current Debt / Equity

Interest Coverage Ratio

Today’s D/E ratio, or what would today’s D/E look like if MH borrowed another $20 million

63
Q

Standard Ratio Analysis tells us about the present situation

useful approach is to

A

estimate forward predictions of the firm’s ability to meet repayments promised, using the Cash Flow Coverage Ratio

64
Q

cash flow coverage ratio

A
65
Q

Debt Service Coverage Ratio

A

Interest coverage ratio (earnings basis) or interest coverage ratio (cash flow basis)

EBITDA/ interest expense

66
Q

fixed charges ratio

A

add required rent payments to the denominator, and subtract rent expense (or payments) from the numerator

67
Q

Examine Projected Forward Ratios and Cash Flows

• We can use

A

forecasts for Michael Hill’s future Sales / Profits / Operating Assets etc and examine:

– Projected Free Cash Flows to the Firm (Debt and Equity), from which debt must be serviced

– Projected Cash Flow Coverage Ratios

• Then adjust our assumptions re Sales / Profit Margins etc to see impact on cash flows and coverage

68
Q

How to Estimate the Principal Repayments

• Some options:

A

– Use current cash flow statement to get ‘Repayments of Debt’ ‘Interest Paid’ and extrapolate from that

– If debt is in form of standard principal and interest loan(s), and age (average age) of loans is known, can use loan amortisation table to approximate principal / interest payments now and in future years

– Notes to financial statements detailing firm’s liquidity risk may provide sufficient information if the firm uses public debt with known maturities

– If debt is in form of revolving credit line, examine the terms of the facility

69
Q

How to Estimate the Principal Repayments

• Some options:

A

– Use current cash flow statement to get ‘Repayments of Debt’ ‘Interest Paid’ and extrapolate from that

– If debt is in form of standard principal and interest loan(s), and age (average age) of loans is known, can use loan amortisation table to approximate principal / interest payments now and in future years

– Notes to financial statements detailing firm’s liquidity risk may provide sufficient information if the firm uses public debt with known maturities

– If debt is in form of revolving credit line, examine the terms of the facility

70
Q

What does this show

A

MH made no principal repayments during year:

71
Q

While ever MH stays within the limits of its Bank Bill facility the only cash it is obliged to pay to ANZ

A

will be nterest

– Pays $100 at maturity of Bill, but by ‘rolling’ the Bill the bank give back $95, the $5 diff = interest

72
Q

However, if MH reduces its outstanding debt, then

A

principal will be repaid

– Pays $100 at maturity and decides NOT to ‘roll’ the bill, $5 interest, $95 principal repayment

73
Q

why are bank bills considered long term

A

due to continuous rolling of bank bills

74
Q

Find CFO

A

Net Income – Increase Operating WC + Depreciation

– assumed depreciation rate (applied to opening Net LT OP Assets) of 20%

– For 2007 this yields a Depreciation Expense of 7,549

75
Q

Net income

A

NOPAT - Net Interest Expense after tax

76
Q

Depreciation for cash flow coverage ratio

CFO = Net Income – Incr. OP. WC + Depreciation

A

dep rate x opening net long term operating assets

77
Q

CFO = Net Income – Incr. OP. WC + Depreciation

Increase operating working capital for 2007

A

Opening operating working capital 2008 - opening operating working capital 2007

78
Q

CFO Before Interest and Tax

A

CFO + Net Int Exp After Tax +Tax Paid on NOPAT

79
Q

CFOB4IT = CFO + Net Int Exp After Tax +Tax Paid on NOPAT

Tax paid on NOPAT

A
80
Q

Estimating the Interest and Principal Payments for MH 2007

• Forecast Interest Payments (Before Tax):

A
81
Q

Forecasting Principal Repayments (Revolving Bill Facility)

what do we look at

A

Forecast Debt ratio:

  • forecast assumptions included a gradual reduction in MH’s proportionate use of Debt to finance its Assets

Sales Growth Forecast

  • sales are growing –> Net Op Assets are growing
82
Q

Forecasting Principal Repayments (Revolving Bill Facility)

If the impact of the Lower Debt Ratio outweighs the effect of asset growth

A

the reduction in Net Debt is a good estimate of principal repayments

83
Q

Forecasting Principal Repayments

If Michael Hill’s Net Debt in 2006 was $58,046 and the Net Debt required to support 2007 sales at the assumed Debt Ratio is $56,206

What then?

A

Net Reduction in Debt of $1,840
– This implies a principal repayment of $1,840

84
Q

What does cash flow coverage above 1 mean

MH has cash flow coverage ratio of 6.270

A

A ‘safe’ firm should have a cash flow coverage ratio well in excess of 1

– Given it’s current financial position, and projected future performance / position, Michael Hill should have little trouble obtaining additional debt should it desire to

85
Q

Forecasting assumptions

A
86
Q

Income Statement Forecasting

A
87
Q

NOPAT

A

NOPAT Margin x Sales

88
Q

Net interest expense after tax

A

After tax cost of debt x net debt

89
Q

Beginning balance sheet (forecasting)

A

Beginning net WC = net working working to sales x sales

beginning Net long term operating = long term operating to sales x sales

90
Q

Beginning balance sheet

Net debt

Opening equity

A

Net debt = net debt ratio x opening net operating assets

Opening equity = Opening Net Operating Assets - Net Debt

91
Q

Net capital beginning and net capital closing

A
92
Q

Net capital beginning

A

Net debt + preference shares + opening equity

93
Q

Net income to common

A

Net income - preference dividends

94
Q

Dividends paid

A

Dividend payout rate x opening equity

95
Q

Closing Equity

A

Opening equity for NEXT YEAR

96
Q

equity issues

A

Closing equity - opening equity - dividends paid - net income to common

97
Q

Tax on NOPAT

A

Tax Rate x (NOPAT / (1-Tax Rate))

98
Q

Interest expense after tax

A

After-tax cost of debt x net debt

99
Q

Interest expense BEFORE tax

A

Interest expense AFTER tax / (1 - corporate tax rate)

(after tax cost of debt x net debt) / (1 - corporate tax rate)

100
Q

Principal repayment

A

Debt Principal Repayments Assuming only Net Debt Reductions Require Cash

Forecast debt principal payment for 2007

IF 2007 net debt < 2006 net debt, principal repayment = 2006 net debt - 2006 net debt

IF 2007 net debt > 2006 net debt, principal repayment = 0

101
Q

Cash flow coverage ratio assuming debt is called in

A

Cash flow coverage ratio assuming debt is called in 2007

CFO + Tax paid + interest paid / (Interest payments pre-tax + net debt 2007)/ 1 - corporate tax rate

* Michael Hill’s Debt comprises a rolling bank bill facility

102
Q

Traditional interest coverage analysis

Interest coverage ratio

A

EBIT/ interest payments before tax

103
Q

Traditional interest coverage analysis

Interest coverage ratio

EBIT/ interest payments before tax

EBIT =

A

EBIT = Estimated Tax Paid on NOPAT + NOPAT

104
Q

Traditional interest coverage analysis

Interest coverage ratio

EBIT/ interest payments before tax

Estimated tax paid on NOPAT

A

Tax rate x (NOPAT/ 1- tax rate)

105
Q

Free Cash flow to Capital

A
106
Q

assumed reductions in the investment in LT Op Assets

can

A

lead to large increases in FCF to firm

107
Q

Be careful interpreting large increases in FCF to Firm caused by assumed reductions in the investment in LT Op Assets

why??

A

– Sometimes the reduction is difficult to achieve (can’t sell the assets for their book value)

– If Sales Growth is –ve, the assets that produce those sales might be hard to sell…..or can only be sold at price below net book value.

108
Q

What if MH’s Debt Facility was terminated

A

MH’s bank terminates their Bill Facility, requiring repayment of outstanding principal

– In this case, assumed principal repayment = 100% of the net debt.

109
Q

Why is Debt Analysis relevant for potential equity investors

A

costs of financial distress caused by excessive debt flow through to riskiness of the cash flows to equity (and thus equity holder’s required return)

110
Q

Debt ratings influence

e.g. standard and poor’s D to AAA gradings

A

the yield that debt instruments must pay for investors to buy them.

111
Q

Factors that drive debt ratings

A

– Performance in both earnings and cash flow terms

– Volatility of financial performance and idiosyncratic stock returns

– Leverage

– Firm Size

– Whether debt security is subordinated or not

112
Q

Subordinated Debt

A

other debt has a superior claim on the assets of the issuing firm.

113
Q

Adjusted Available Cash Flow:

A

CFO + Interest Expense (1-T) + Rent Exp (1-T) – Increase in Net LT Operating Assets – Depreciation - Predicted Dividends

114
Q

Cash Flow Cushion

Debt Cash Commitments

A

Interest Expense + Rent Expense + Repayments

115
Q

Cash Flow Cushion

A
116
Q

Higher Credit Score

A

More Likely To Default.

117
Q

Why is excessive dividend payments a problem

A

reduces cash, short term effect

reduce equity, less retained earnings –> increase chance of insolvency

118
Q

Describe underinvestment

A

For companies in distress,

  • when company obtains debt, they know they have obligation to pay back in the future so they withold funds
  • Company wants to invest in higher return –> higher risk
  • Underinvestment in lower risk but with positive NPV (bias against low risk positive NPV investments)
119
Q

Another value reducing behaviour

Asset substitution

A

Switch current low asset portfolio to higher risk portfolio to obtain higher return with the funds

120
Q

Claim dilution

A

take on extra debt which may dilute existing creditors’ claim

121
Q

Risk of companies taking on debt

A
  1. Increase financial risk caused by leverage change
  • Increased interest on profit
    1. change in borrower behaviour (excessive dividend payment, underinvest)
  • downside risk is shared between borrower and lender –> willing to engage in more risk
122
Q

What are two debt covenants

A
  1. Early warning system: debt covenant will set a debt ratio, if company breaches debt ratio, creditor has right to call back loan
  2. Limit risk taking behaviour of borrowers
    - limit the downside risk shared by creditors
123
Q

what is revolving credit facility

A

borrower pays bank commitment fee.

Bank allows borrower to withdraw funds from them whenver they need

provide the borrower with a line of credit that can be drawn down when needed

124
Q

effect of revolving credit facility

A

increase debt ratio and debt/asset quickly, makes loan process much easier

affects the riskiness of other debts acquired by the firm

125
Q

what are traditional ratios

A

based on accrual performance and backward looking

126
Q

how to manipulate cash flow

SP 100

70

30% gross profit margin

A

at purchase, increase inventory 70, increase AP by 70

at sale, decrease inventory by 70, increase COGS 70, increase sales revenue 100, increase AR or cash by 100

assume other expenses 20

Effect on profit: 100 (sales revenue) - 70 (COGS) - other expenses = net profit 10

Financial Analysis (10 decks)

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