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:
What is the Lender Worried About?
• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:
- excessive dividend payouts
- Under investment
- asset substitution
- claim dilution
What is the Lender Worried About?
• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:
1. excessive dividend payouts
reduces owner’s equity, increasing chance of insolvency
What is the Lender Worried About?
• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:
1. Under investment
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
What is the Lender Worried About?
• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:
3. Asset substitution
changing the firm’s overall asset structure after acquiring debt – from lower risk to higher risk
What is the Lender Worried About?
• Debtholder-Shareholder relationships create incentive for 4 general types of value-reducing behaviour:
4. claim dilution
aking on extra debt which may dilute the existing creditors’ claim on the firm in liquidation
So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship
Include covenants in loan agreement
So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship
covenant in loan agreement
MINIMUM NET WORTH
(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)
So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship
covenant in loan agreement
Minimum ‘Coverage’ Ratios
ratio of EBIT / interest expense
or EBIT / Estimated Repayments on Loan
Cash flow-based coverage also possible
So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship
Debt covenant
Maximum Leverage
Total Liabilities / Equity or
Total Liabilities / Net Tangible Assets
So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship
Debt covenant
Which covenant forces borrower to maintain liquidity
Minimum Net Working Capital or Current Ratio:
So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship
Debt covenant
Which covenant directly limits growth funded externally
Maximum Capital Expenditure / EBITDA
So What Does the Lender Do About Value Reducing Behaviour from debtholder to shareholder relationship
Debt covenant
Negative Pledges
Promises to refrain from behaviour such as issuing new debt, assigning security interests in existing assets etc
Breach of a debt covenant allows the lender to:
- Renegotiate the terms of the loan (most common outcome)
- Waive the breach
- Accelerate repayments
• Call in the loan in its entirety
The types of credit sought/granted are related to:
- term to maturity / duration of the assets acquired / already owned by the borrower
- Riskiness of firm’s cash flows
- Collateral value of assets available to secure the debt
- How much debt the firm has already incurred
Bank loans
Terms typically
0-15 years
Bank loans
Different repayment patterns, including
– Standard amortisation – constant annual payment, early payments largely interest, later payments largely reflect principal reduction
– Interest-only period
Bank loans
Interest rates
Fixed or Variable Interest Rates
Bank loans
Security
May be secured by claim over assets
Public Debt
Firms may issue bonds/debentures to the market
Public Debt
Bonds and debentures
Promises to pay a (usually) fixed periodic interest payment (‘the coupon’) and the face value of the bond upon maturity
Public Debt
Secondary market
Initial investor in the bond can sell the bond to other investor
Revolving Credit Facilities
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
Revolving Credit Facilities
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
Some companies (such as Michael Hill) have a revolving Bank Bill facility, under which their
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
Revolving credit facility
what happens when one of the ST debt instruments reaches maturity
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
Revolving credit facilities
Commercial Bank Bill facilities may
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’
Revolving bank bill facility
1 Jan 2014: Michael Hill issues a $100 180-day Bill
– Bank pays MH $95 for the Bill
– 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
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:
– 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
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,
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
The continuation of the revolving facility is
subject to annual reviews of the creditworthiness of the borrower.
While ever MH’s debt financing requirements are
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
liabilities owing on a revolving bill facility is
$62.1m
what is net debt owing at the end of 2006 fin year
where there is $4m of cash:
about $58m, arising from liabilities owing on a revolving bill facility ($62.1m) and about $4m of cash:
MH have agreed access to credit?
MH have agreed access to $77,640m of credit from ANZ bank ($3,165m in overdraft; $74,475m in Bill facility)
are they using bank overdraft facility?
They are not using the overdraft at 30/6/2006
what is their outstanding bills payable?
They have outstanding Bills Payable of $62,134
how can we assess Michael Hill’s present creditworthiness
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
Standard Ratio Analysis tells us about the present situation
What do we try to find
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
Standard Ratio Analysis tells us about the present situation
useful approach is to
estimate forward predictions of the firm’s ability to meet repayments promised, using the Cash Flow Coverage Ratio
cash flow coverage ratio
Debt Service Coverage Ratio
Interest coverage ratio (earnings basis) or interest coverage ratio (cash flow basis)
EBITDA/ interest expense
fixed charges ratio
add required rent payments to the denominator, and subtract rent expense (or payments) from the numerator
Examine Projected Forward Ratios and Cash Flows
• We can use
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
How to Estimate the Principal Repayments
• Some options:
– 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
How to Estimate the Principal Repayments
• Some options:
– 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
What does this show
MH made no principal repayments during year:
While ever MH stays within the limits of its Bank Bill facility the only cash it is obliged to pay to ANZ
will be nterest
– Pays $100 at maturity of Bill, but by ‘rolling’ the Bill the bank give back $95, the $5 diff = interest
However, if MH reduces its outstanding debt, then
principal will be repaid
– Pays $100 at maturity and decides NOT to ‘roll’ the bill, $5 interest, $95 principal repayment
why are bank bills considered long term
due to continuous rolling of bank bills
Find CFO
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
Net income
NOPAT - Net Interest Expense after tax
Depreciation for cash flow coverage ratio
CFO = Net Income – Incr. OP. WC + Depreciation
dep rate x opening net long term operating assets
CFO = Net Income – Incr. OP. WC + Depreciation
Increase operating working capital for 2007
Opening operating working capital 2008 - opening operating working capital 2007
CFO Before Interest and Tax
CFO + Net Int Exp After Tax +Tax Paid on NOPAT
CFOB4IT = CFO + Net Int Exp After Tax +Tax Paid on NOPAT
Tax paid on NOPAT
Estimating the Interest and Principal Payments for MH 2007
• Forecast Interest Payments (Before Tax):
Forecasting Principal Repayments (Revolving Bill Facility)
what do we look at
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
Forecasting Principal Repayments (Revolving Bill Facility)
If the impact of the Lower Debt Ratio outweighs the effect of asset growth
the reduction in Net Debt is a good estimate of principal repayments
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?
Net Reduction in Debt of $1,840
– This implies a principal repayment of $1,840
What does cash flow coverage above 1 mean
MH has cash flow coverage ratio of 6.270
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
Forecasting assumptions
Income Statement Forecasting
NOPAT
NOPAT Margin x Sales
Net interest expense after tax
After tax cost of debt x net debt
Beginning balance sheet (forecasting)
Beginning net WC = net working working to sales x sales
beginning Net long term operating = long term operating to sales x sales
Beginning balance sheet
Net debt
Opening equity
Net debt = net debt ratio x opening net operating assets
Opening equity = Opening Net Operating Assets - Net Debt
Net capital beginning and net capital closing
Net capital beginning
Net debt + preference shares + opening equity
Net income to common
Net income - preference dividends
Dividends paid
Dividend payout rate x opening equity
Closing Equity
Opening equity for NEXT YEAR
equity issues
Closing equity - opening equity - dividends paid - net income to common
Tax on NOPAT
Tax Rate x (NOPAT / (1-Tax Rate))
Interest expense after tax
After-tax cost of debt x net debt
Interest expense BEFORE tax
Interest expense AFTER tax / (1 - corporate tax rate)
(after tax cost of debt x net debt) / (1 - corporate tax rate)
Principal repayment
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
Cash flow coverage ratio assuming debt is called in
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
Traditional interest coverage analysis
Interest coverage ratio
EBIT/ interest payments before tax
Traditional interest coverage analysis
Interest coverage ratio
EBIT/ interest payments before tax
EBIT =
EBIT = Estimated Tax Paid on NOPAT + NOPAT
Traditional interest coverage analysis
Interest coverage ratio
EBIT/ interest payments before tax
Estimated tax paid on NOPAT
Tax rate x (NOPAT/ 1- tax rate)
Free Cash flow to Capital
assumed reductions in the investment in LT Op Assets
can
lead to large increases in FCF to firm
Be careful interpreting large increases in FCF to Firm caused by assumed reductions in the investment in LT Op Assets
why??
– 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.
What if MH’s Debt Facility was terminated
MH’s bank terminates their Bill Facility, requiring repayment of outstanding principal
– In this case, assumed principal repayment = 100% of the net debt.
Why is Debt Analysis relevant for potential equity investors
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)
Debt ratings influence
e.g. standard and poor’s D to AAA gradings
the yield that debt instruments must pay for investors to buy them.
Factors that drive debt ratings
– 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
Subordinated Debt
other debt has a superior claim on the assets of the issuing firm.
Adjusted Available Cash Flow:
CFO + Interest Expense (1-T) + Rent Exp (1-T) – Increase in Net LT Operating Assets – Depreciation - Predicted Dividends
Cash Flow Cushion
Debt Cash Commitments
Interest Expense + Rent Expense + Repayments
Cash Flow Cushion
Higher Credit Score
More Likely To Default.
Why is excessive dividend payments a problem
reduces cash, short term effect
reduce equity, less retained earnings –> increase chance of insolvency
Describe underinvestment
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)
Another value reducing behaviour
Asset substitution
Switch current low asset portfolio to higher risk portfolio to obtain higher return with the funds
Claim dilution
take on extra debt which may dilute existing creditors’ claim
Risk of companies taking on debt
- Increase financial risk caused by leverage change
- Increased interest on profit
- change in borrower behaviour (excessive dividend payment, underinvest)
- downside risk is shared between borrower and lender –> willing to engage in more risk
What are two debt covenants
- Early warning system: debt covenant will set a debt ratio, if company breaches debt ratio, creditor has right to call back loan
- Limit risk taking behaviour of borrowers
- limit the downside risk shared by creditors
what is revolving credit facility
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
effect of revolving credit facility
increase debt ratio and debt/asset quickly, makes loan process much easier
affects the riskiness of other debts acquired by the firm
what are traditional ratios
based on accrual performance and backward looking
how to manipulate cash flow
SP 100
70
30% gross profit margin
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
