week 11 Flashcards
Why Do Firms Use Debt?
- Interest on debt is tax-deductible
- Help existing shareholders maintain control of company
- Increase earnings per share (if investment is successful)
The Credit Analysis Process in Private Debt Markets
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.
The Credit Analysis Process in Private Debt Markets
2.
- 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.
The Credit Analysis Process in Private Debt Markets
3.
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.
The Credit Analysis Process in Private Debt Markets
4.
- Use forecasts to assess payment prospects
The Credit Analysis Process in Private Debt Markets
- Use forecasts to assess payment prospects:
who are the forecasts made by
The forecasts are typically made by management and should be subjected to significant scrutiny.
The Credit Analysis Process in Private Debt Markets
- Use forecasts to assess payment prospects:
What does this involve
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.
The Credit Analysis Process in Private Debt Markets
5.
- Assemble loan structure and debt covenants (if loan is to be offered).
The Credit Analysis Process in Private Debt Markets
- Assemble loan structure and debt convenants
describe
Loan covenants specify mutual expectations of the borrower and lender
The Credit Analysis Process in Private Debt Markets
Key covenant terms include:
the borrower promising to maintaining specific financial conditions.
• The borrower promising not to take certain actions (e.g. taking out additional secured loans)
The Credit Analysis Process in Private Debt Markets
the final step is to
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)
Creditors Emphasise Downside Risk
what does this mean
Potential creditors place greater emphasis on the likelihood of poor financial performance
Creditors Emphasise Downside Risk
– ‘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
Creditors Emphasise Downside Risk
– ‘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
Equity v Credit Investment – Considerations Prior to Investment Decision
• Potential equity investors are interested in
Potential equity investors are interested in understanding the full distribution of (expected) future returns
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
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
After a debt agreement is in place,
the incentives facing managers (as representatives of equity holders) may change
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
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
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
Debt Covenants have two main purposes:
Firstly
Act as an ‘early warning’ system, allowing the creditor to take steps to protect their interests as the outstanding debt becomes riskier
Debt Covenants have two main purposes:
Secondly
Control the risk-taking behaviour of the borrower by aligning borrower incentives with that of the lender
• Mitigate the ‘agency costs of debt’,
Agency Costs of Debt
• An ‘agency’ relationship exists where
the lender (owner of an asset) grants decision making authority over that asset to the borrower (equity holders of the borrowing firm; agent)
Agency Costs of Debt
Borrower’s decisions affect the return to the Lender
– Borrower may try to transfer wealth to equity holders, at the expense of debt holders.
What is the Lender Worried About?
• Debtholder-Shareholder relationships create
Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:

































