Credit Risk and the Value of Corporate Debt Chapter 23 Principles of Corporate Finance Tenth Edition Credit Risk and the Value of Corporate Debt Slides by Matthew Will McGraw Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered Yields on Corporate Debt The Option To Default Bond Ratings and the Probability of Default Predicting the Probability of Default Value at Risk

Valuing Risky Bonds Example A: Bond Value Prob 1,050 .80 = 840.00 We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value? A: Bond Value Prob 1,050 .80 = 840.00 500 .20 = 100.00 . 940.00 = expected CF

Valuing Risky Bonds Example – Continued Conversely - If on top of default risk, investors require an additional 3 percent market risk premium, the price and YTM is as follows:

Yield Spreads Yield Spread, %

Credit Default Swap Data Credit default swaps insure holders of corporate bonds against default. Dow Jones indexes of spreads on default swaps measure the annual insurance premium. Spread, %

Key to Bond Ratings The highest quality bonds are rated triple-A. Investment grade bonds have to be equivalent of Baa or higher. Bonds that don’t make this cut are called “high-yield” or “junk” bonds.

Bond Ratings and Financial Ratios Three years of median ratio data by bond rating (2002– 2004).

Bond Ratings and Default Default rates of corporate bonds 1981-2005 by S&P’s rating at time of issue

Credit Analysis Credit analysis is only worth while if the expected savings exceed the cost. Don’t undertake a full credit analysis unless the order is big enough to justify it. Undertake a full credit analysis for the doubtful orders only. 16

Asset Value and Default The market value of WorldCom assets, as default approached Value, $ millions Default date

Value at Risk (VaR) Value at Risk = VaR Newer term Attempts to measure risk Risk defined as potential loss Limited use to risk managers Factors Asset value Daily Volatility Days Confidence interval

Value at Risk (VaR) Standard Measurements 10 days 99% confidence interval VaR

Value at Risk (VaR) Example You own a $10 mil portfolio of IBM bonds. IBM has a daily volatility of 2%. Calculate the VaR over a 10 day time period at a 99% confidence level.

Ratings Changes