Leeds School of Business | University of Colorado Boulder



Chapter 22Answer the below questions.What is the difference between a positive and negative covenant?Positive (or affirmative) covenants require that the borrower to take certain actions. Negative (or restrictive) covenants require that the borrower not take certain actions. Some of the more common restrictive covenants in bond indentures (bond contracts) include limitations on the company’s ability to incur new debt such as limits on the absolute dollar amount of outstanding debt or an interest coverage ratio minimum. There could also be cash flow tests (minimums) or working capital minimums. There may also be limits on dividends or other payouts.Some covenants may prohibit subsidiaries of the firm from borrowing from all other companies except the parent. Indentures often classify subsidiaries as restricted or unrestricted. Restricted subsidiaries are those considered to be consolidated for financial test purposes; unrestricted subsidiaries (often foreign and certain special-purpose companies) are those excluded from the covenants governing the parent. Often, subsidiaries are classified as unrestricted in order to allow them to finance themselves through outside sources of funds.What is the purpose of the analysis of covenants in assessing the credit risk of an issuer?Bond covenants are often safeguards for the bondholders and can identify areas of concern for the potential bond buyer. Covenants must also be analyzed for ambiguity. Bond analyst must pay careful attention to the definitions in indentures because they vary from indenture to indenture. For example an “interest coverage ratio” may have “EBITDA” or “free cash flows” in the numerator.Bonus Question: What happens if a covenant is violated? If a covenant is violated, the bond is in technical default. This might trigger a repayment clause requiring the bond to be immediately repaid (so the holder can “put” the bond to the issuer). It might trigger an automatic downgrade of the debt. Answer the below questions.What is a maintenance test?In the context of bond covenants, a maintenance test “tests” the levels of cash flows relative to fixed expenses or cash flows relative to interest expenses (interest coverage or fixed-charge coverage ratios) to ensure they are above the minimum levels described in the bond’s covenants.What is a debt incurrence test and when does it come into play?In the context of bond covenants, a debt incurrence test ensures that new debt can only be acquired if interest coverage ratio or fixed-charge coverage ratio adjusted for the new debt will meet the minimum level for the required period. Some credit analysts place less emphasis on collateral compared to covenants and business risk (when analyzing unsecured bonds). Explain why.Analysts place more emphasis on covenants and business risk than collateral since bankruptcy often only allows secured creditors, with specific assets pledged to secure a loan, to recover money. Recall that a corporate debt obligation can be either secured or unsecured and there are two types of bankruptcy: liquidation and reorganization. In the case of the liquidation of a corporation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule. In contrast, seldom do the absolute priority rules hold in a reorganization. What is typically observed in in reorganizations is that the corporation’s unsecured creditors may receive distributions for a portion of the amount of their claim and common stockholders may receive some distribution, even if the secured creditors (with priority over the unsecured and stock holders) receive only a portion of their claim. Secured creditors are willing to allow some distribution to unsecured creditors and common stockholders in order to obtain approval for the reorganization plan, which requires the approval of all parties.Even though a secured credit position does not ensure total recovery in the event of a reorganization, it does give the more power in the reorganization negotiation process.Why do credit analysts begin with an analysis of (the macro-economy and then) the industry (before) assessing the business risk of a corporate issuer?Macro-economic analysis (growth and cyclicality) and industry analysis (industry growth, composition, and market share) are critical to effective company analysis. For example, suppose that sales growth for a company over the past three years was 20% per year. Margins have been relatively constant so cash flows (EBITDA) has been growing at a high rate. In isolation, this growth is a good indication.But what if this company is in a highly cyclical (high beta) industry (such as business software) and the economy has been growing at 10% per year over the period but that growth rate is expected to decrease? Also, what if, over the same period, the industry in which the company operates has been growing at 40% per year while the company is growing at only 20%? So the company’s market share has fallen precipitously. The company’s business risk may seem greater and the bonds less attractive than if only the 20% growth rate was considered. What is the purpose of a credit analyst investigating the market structure of an industry (e.g., unregulated monopoly, oligopoly, etc.)?A credit analyst will look at the market structure of an industry (e.g., unregulated monopoly, oligopoly, etc.) because of its implications regarding factors such as product price, supply, product quality, distribution capabilities, corporate image, product differentiation, or product service. What should be the focus of an analyst with respect to the regulation of an industry?Analysis often focus on the direction of future regulation and its possible impact on the expected profitability (cash flows) of a company. The underlying economic theory regarding many corporate governance issues is the principal-agency relationship between the senior managers and the shareholders of corporations. Explain this relationship.Standard agency theory advocates that principals (owners or stockholders) must monitor agents (managers) to insure that they will properly carry out their fiduciary responsibility to increase shareholder wealth.In the context of bonds, the agents are senior managers who are charged with the responsibility of acting on behalf of the principal (the shareholders) of the corporation. Principal-agent problems (sometimes called agency costs) include managers using company resources for their own enjoyment (perks). Methods to align the interests of managers and owners such as bonuses for good performance or stock options have created a new class of agency problems associated with managers doctoring the books (either illegally or legally through “earnings management”) to achieve a high earnings in order to boost the stock price. This has led to increased costs associated with monitoring managers and in some cases government regulation.With respect to corporate governance, what are the mechanisms that can mitigate the likelihood that management will act in its own self-interest?The mechanisms (that can mitigate the likelihood that management will act in its own self-interest) fall into two general categories. The first category involves strongly aligning the interests of management with those of shareholders. This can be accomplished by granting management an economically meaningful equity interest in the company. Also, manager compensation can be linked to the performance of the company’s long-run common stock price. The second category involves the company’s internal corporate control systems, which can provide a way for effectively monitoring the performance and decision-making behavior of management. For example, it would allow the timely removal of the CEO by the board of directors who believe that a CEO’s performance is not in the best interest of the shareholders. In general, there are several critical features of an internal corporate control system that are necessary for the effective monitoring of management. What has been clear in corporate scandals is that there was a breakdown of the internal corporate control systems that lead to corporate difficulties and the destruction of shareholder wealth. More details are given below.Because of the important role played by the board of directors, the structure and composition of the board are critical for effective corporate governance. The key is to remove the influence of the CEO and senior management on board members. This can be done in several ways. First, while there is no optimal board size, the more members there are, the less likely the influence of the CEO. With more board members, a larger number of committees can be formed to deal with important corporate matters. At a minimum, there should be an auditing committee, a nominating committee (for board members), and a compensation committee.Second, the composition of the committee should have a majority of independent directors, and the committees should include only independent directors. There are two classes of members of the board of directors. Directors who are employees of management or have some economic interest as set forth by the SEC (for example, a former employee with a pension fund, the relative of senior management, or an employee of an investment banking firm that has underwritten the company’s securities) are referred to as “inside directors.” Board members who do not fall into the category of inside directors are referred to as “outside directors” or “independent directors.”Finally, there are corporate governance specialists who believe that the CEO should not be the chairman of the board of directors because such a practice allows the CEO to exert too much influence over board members and other important corporate actions. This is a position that has been taken by the Securities and Exchange Commission.Answer the below questions.What are corporate governance ratings?Corporate governance ratings refer to the ratings received by corporation in regard to their adherence to the standards and codes of best practice for effective corporate governance. The standards of best practice that have become widely accepted as a benchmark to rate companies on corporate govern are those set forth by the Organization of Economic Cooperation and Development (OECD) in 1999. Other entities that have established standards and codes for corporate governance are the Commonwealth Association for Corporate Governance, the International Corporate Governance Network, and the Business Roundtable. Countries have established their own code and standards using the OECD principles. The standards and codes of best practice go beyond applicable securities law. The expectation is that the adoption of best practice for corporate governance is a signal to investors about the character of management. There is empirical evidence supporting the relationship between corporate governance and bond ratings (and hence bond yields).Are corporate governance ratings reported to the investing public?Several organizations have developed services that assess corporate governance and express their view in the form of a rating. Generally, these ratings are made public at the option of the company requesting an evaluation. One such service is offered by S&P, which produces a Corporate Governance Score based on a review of both publicly available information, interviews with senior management and directors, and confidential information that S&P may have available from its credit rating of the corporation’s debt.What factors are considered by services that assign corporate governance ratings?For a look at the factors considered by services that assign corporate governance ratings, consider S&P’s Corporate Governance Score. This score is based on information attained both privately and publicly and includes interviews with managers and knowledge attained from its credit rating of the corporation’s debt. The score takes into consider the following factors. First is the ownership structure and external influences. This factor includes the transparency of ownership structure and the concentration and influence of ownership and external stakeholders. The second factor involves shareholder rights and stakeholder relations. This factor consists of shareholder meetings and voting procedures, ownership rights and takeover defenses and stakeholder relations. The third factor is transparency, disclosure, and audit that include content of public disclosure, timing of and access to public disclosure, and the audit process. The fourth factor is the board structure and effectiveness that consists of the board structure and independence, the role and effectiveness of the board, and the director and senior executive compensation.Based on S&P’s analysis of these four key factors, its assessment of the company’s corporate governance practices and policies and how its policies serve shareholders and other stakeholders is reflected in the Corporate Governance Score. The score ranges from 10 (the highest score) to 1 (the lowest score). In addition to corporate governance, credit analysts look at the quality of management in assessing a corporation’s ability to pay. Moody’s notes the following regarding the quality of management:Although difficult to quantify, management quality is one of the most important factors supporting an issuer’s credit strength. When the unexpected occurs, it is a management’s ability to react appropriately that will sustain the company’s performance. Assessment of management’s plans in comparison with those of their industry peers can also provide important insights into the company’s ability to compete, how likely it is to use debt capacity, its treatment of its subsidiaries, its relationship with regulators, and its position vis-à-vis all fundamentals affecting the company’s long-term credit strength.In assessing management quality, Moody’s tries to understand the business strategies and policies formulated by management. The factors Moody’s considers are: strategic direction, financial philosophy, conservatism, track record, succession planning, and control systems.Explain what a credit analyst should do in preparation for an analysis of the financial statements.Before performing an analysis of the financial statement, the credit analyst must determine if the industry in which the company operates has any special accounting practices, such as those in the insurance industry. If so, an analyst should become familiar with industry practices. Moreover, the analyst must review the accounting policies to determine whether management is employing liberal or conservative policies in applying generally accepted accounting principles (GAAP). An analyst should be aware of changes in GAAP policies by the company and the reason for any changes. Since historical data are analyzed, the analyst should recognize that companies adjust prior years’ results to accommodate discontinued operations and changes in accounting that can hide unfavorable trends. This can be done by assessing the trends for the company’s unadjusted and adjusted results.Answer the below questions.What is the purpose of an interest coverage ratio?The purpose of an interest coverage ratio (EBITDA/Int Exp) is to measure the money available relative to make interest payments relative to amount of payments. What does an interest coverage ratio of 1.8× mean? An interest coverage ratio of greater than 1.0× means there is more pretax cash from operations to than interest expense. Therefore the company does not need to borrow money or sell assets to meet its interest payments. A ratios of 1.8× implies a safety cushion since a ratio of 1.0× means just enough to cover interest payments. Why are interest coverage ratios typically computed on a pretax basis?Since interest payments are pre-tax payments, Interest payments lower a company’s taxable income and therefore lower tax expense. Why would a fixed charge coverage ratio be materially different from an interest coverage ratio?Fixed charges (or fixed costs) include the parts of COGS and SG&A that are fixed and not variable including leases, fixed labor costs or fixed manufacturing costs. The Fixed charge coverage ratio is (EBITDA + Fixed Costs)/(Interest Exp + Fixed Costs).Although sometimes its (EBIT + Fixed Costs)/(Interest Exp + Fixed Costs).It is materially different from an interest coverage ratio if there are significant fixed obligations such as leases and other fixed manufacturing costs. Answer the below questions.What is the purpose of a leverage ratio?A leverage ratio (Equity-to-Assets, Assets-to-Equity, Debt-to-Equity, Long-Term-Debt to Equity,) determines what proportion of a firm’s financing is composed of debt. The higher the level of debt, the higher the percentage of operating income that must be used to satisfy fixed obligations. If other words, the greater the portion of EBITDA that must go to interest expense (or “I”). Everything else equal, a higher leverage ratio indicates a greater the probability of default.What measures are used in a leverage ratio for total capitalization?It is common to use the book value of equity from the balance sheet from the most recent quarter (MRQ). An analyst might also calculate the current market value of equity to supplement this measure.What is the margin of safety measure?The margin of safety is defined as the percentage by which operating income (EBITDA) could decline and still be sufficient to allow the company to meet its fixed obligations. The margin of safety for a company must be compared to an industry average. Average margins of safety varies dramatically between industries. A lower margin of safety is acceptable in industries that are less cyclical. Other factors must be considered when evaluation the margin of safety including the maturity structure of the debt (the current or soon-to-be-current portion of long-term debt) and bank lines of credit. Analysts must consider the ability of the firm to refinance maturing debt and the likelihood of the continuance of the company’s bank lines of credit.Why do analysts investigate the bank lines of credit that a corporation has?A firm’s bank lines of credit often constitute a significant portion of its total debt and are often the first place a company will borrow. Lines of credit need to be analyzed to determine the flexibility afforded to the company. The lines of credit should be evaluated in terms of undrawn capacity as well as a determination as to if the line contains a “material adverse change” clause under which the bank may withdraw a line of credit.In the analysis of net assets, what factors should be considered?In the analysis of net assets (and any financial ratio involving net assets such as “net assets to total debt”), consideration should be given to the liquidation value of the assets. Liquidation value will often differ dramatically from the book value on the balance sheet. A company with a high percentage of its assets in cash and marketable securities is in a much stronger asset position than a company whose primary assets are illiquid real estate or machinery. Consideration should also be given to intangible assets, pension liabilities, and the age and condition of the fixed assets. Companies with greater intangible assets will typically have a lower liquidation value. Answer the below questions.What is meant by working capital?Working capital current assets less current liabilities. It is a primary measure of a company’s short-term financial flexibility. Working capital measures include the current ratio (current assets divided by current liabilities) and the acid test (cash, marketable securities, and receivables divided by current liabilities). The stronger the company’s liquidity measures, the better it can weather a downturn in business and reduction in cash flow.Why is an analysis of working capital important?An analysis of working capital is important in order to determine a firm’s capacity to meet short-term obligations. The ratios should be compared to industry norms. In addition, the components of working capital (accounts receivable, accounts payable, inventory value and so forth) should be assessed. For example, although accounts receivable are considered to be liquid, an increase in the receivables age may be an indication that a higher level of working capital is needed. Why do analysts of high-yield corporate bonds feel that the analysis should be viewed from an equity analyst’s perspective?Credit analysis of business risk, corporate governance risk, and financial risk all involve the same type of methods that a common stock analyst would undertake. ................
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