1. Credit Analysis Chapter 7 Robinson, Munter, Grant

2. Grant, Munter & Robinson Chapter 72 Learning Objectives Understand debt instruments, accounting disclosures and claim status Understand interest rates and risk considerations Understand bond ratings Perform credit analysis Understand off-balance-sheet financing

3. Grant, Munter & Robinson Chapter 73 Nature of Debt Instruments Creditors receive interest and principal payments they have been promised Creditors do not share in the profits of the firm Credit-granting decisions are based on financial statement analysis and commercial credit ratings –Including off-balance-sheet financing

4. Grant, Munter & Robinson Chapter 74 Debt Covenants Protect lender/bond investor by restricting certain activities (i.e., dividend payments) Intended to provide an early warning system for loans that may be in danger May result in higher bond rating and lower interest rate

5. Grant, Munter & Robinson Chapter 75 Bonds Indenture is the bond document Principal (par or face value) is the amount to be repaid, basis for interest payments Issued in $1,000 increments 10-, 20-, 30-year maturities Coupon or stated rate is the interest rate Secured or unsecured (debenture)

6. Grant, Munter & Robinson Chapter 76 Bonds Sinking fund – used to pay off the loan Puttable or redeemable at the purchaser’s option –Callable – at the issuer’s option Convertible – into another security Senior vs. junior

7. Grant, Munter & Robinson Chapter 77 Bond Selling price Present value of principal and interest payments Par, at face value Discount –Stated rate < investor’s required rate of return Premium –Stated rate > investor’s required rate of return

8. Grant, Munter & Robinson Chapter 78 Interest rates Market rate = Risk free rate + Risk premium Risk free rate ƒ(inflation rate and investor’s desired “real” return) Risk premium – additional return, compensation for uncertainty

9. Grant, Munter & Robinson Chapter 79 Bond investment risks Default risk – issuer unable to make payments Interest rate risk – potential variation in market rates Reinvestment rate risk – investor’s ability to reinvest coupon payments at the same rate Call risk – possibility that issuer will redeem the bond Purchasing power risk – yield < inflation Currency risk – for foreign bonds

10. Grant, Munter & Robinson Chapter 710 Accounting for Debt Instruments Original cost/consideration received Minus principal payments Plus discount amortization Less premium amortization Example: –5-year, $10,000,000 bond –4% semiannual interest payment –5% prevailing market rate

11. Grant, Munter & Robinson Chapter 711 Bond example Issue price = $9,227,827 –Present value of interest, $3,088,694 –Present value of principal, $6,139,133 Discount = $772,173 –Represents additional interest Initially report: Bond par value $10,000,000 Unamortized discount (772,173) Bond Carrying value $ 9,227,827

12. Grant, Munter & Robinson Chapter 712 Bond example

13. Grant, Munter & Robinson Chapter 713 Bond example Market interest drops to 3% Issue price = $ 10,853,020 –Present value of interest, $3,412,081 –Present value of principal, $7,440,939 Premium = $853,020 –Represents a reduction in interest Initially report: Bond par value $10,000,000 Unamortized premium 853,020 Bond Carrying value $10,853,020

14. Grant, Munter & Robinson Chapter 714 Bond example

15. Grant, Munter & Robinson Chapter 715 Credit rating Rely on qualitative and quantitative analyses Standard & Poor’s (AAA to D) –Intermediate “+/-” scores Moody’s (Aaa to C) –Intermediate “1,2,3” scores Fitch (AAA to D)

16. Grant, Munter & Robinson Chapter 716 Standard & Poor’s rating method 1.EBIT interest coverage 2.EBITDA interest coverage 3.Funds from operations/Total debt % 4.Free operating cash flow/Total debt % 5.Return on capital % 6.Operating income/Sales 7.Long-term debt/Capital 8.Total debt/Capital

17. Grant, Munter & Robinson Chapter 717 Financial distress Chapter 11 bankruptcy is a financial reorganization in which the company continues to operate and works with creditors to formulate repayment plans. Chapter 7 bankruptcy is a complete liquidation in which the firm ceases operations and sells all assets. Financial distress can be predicted.

18. Grant, Munter & Robinson Chapter 718 Prediction of financial distress Univariate models Beaver (1966) relied on Cash flow to total debt Net income to total assets Total debt to total assets Working capital to total assets Current ratio No-credit (defensive) interval

19. Grant, Munter & Robinson Chapter 719 Prediction of financial distress Multivariate models Altman Z-score –(Current assets – current liabilities)/total assets –Retained earnings/Total assets –EBIT/Total assets –Preferred and common stock market value/Book value of liabilities –Sales/Total assets Nokia = 9.88 Motorola = 1.71 (below the 2.99 nonbankrupt benchmark)

20. Grant, Munter & Robinson Chapter 720 Motorola Liabilities

21. Grant, Munter & Robinson Chapter 721 Motorola, Note 3

22. Grant, Munter & Robinson Chapter 722 Motorola, Note 3

23. Grant, Munter & Robinson Chapter 723 Motorola, Note 8 Off-balance-sheet financing “At December 31, 2001, future minimum lease obligations, net of minimum sublease rentals, for the next five years and beyond are as follows: 2002—$150 million; 2003— $117 million; 2004—$97 million; 2005—$76 million; 2006— $63 million; beyond—$90 million.” The present value of these payments, at 7%, is $484 million Inclusion of these items increases debt by 5%

24. Grant, Munter & Robinson Chapter 724 Nokia Liabilities

25. Grant, Munter & Robinson Chapter 725 Nokia debt note detail

26. Grant, Munter & Robinson Chapter 726 Nokia debt note detail Operating lease payments

27. Grant, Munter & Robinson Chapter 727 Elements of Free Operating Cash Flow 2001Nokia (EURm)Motorola ($m) EBITDA5,735(4,039) Non-cash items 248(2,273) Fund from operations5,983(6,312) Capital expenditures(1,041)(1,321) Working capital change 9781,527 Free operating cash flow5,920(6,106)

28. Grant, Munter & Robinson Chapter 728 Debt Analysis Ratios

29. Grant, Munter & Robinson Chapter 729 Additional considerations Mezzanine items –Could be debt or equity Off-balance-sheet liabilities –Operating leases –Contingent liabilities –Environmental liabilities

30. Grant, Munter & Robinson Chapter 730 Summary Debt, interest, risk and covenants Bonds –Discount and premium Risk analysis Financial statement presentation Financial statement analysis