Principles
of
Corporate
Finance
Tenth Edition
Chapter 23
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
24- 2
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
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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
24- 3
Valuing Risky Bonds
Example
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
Value 
 $895
1.05
1050
YTM 
 1  17.3%
895
McGraw Hill/Irwin
.
940.00 = expected CF
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
24- 4
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:
940
Value 
 $870.00
1.08
1050
YTM 
 1  20.7%
870.00
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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
24- 5
Yield Spreads
12
10
Aaa
Baa
High yield
Yield Spread, %
8
6
4
2
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
0
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
2005-04-13
2005-04-29
2005-05-17
2005-06-03
2005-06-21
2005-07-08
2005-07-26
2005-08-11
2005-08-29
2005-09-15
2005-10-03
2005-10-20
2005-11-07
2005-11-25
2005-12-13
2005-12-30
2006-01-19
2006-02-06
2006-02-23
2006-03-13
2006-03-29
2006-04-17
2006-05-03
2006-05-19
2006-06-07
2006-06-23
2006-07-12
2006-07-28
2006-08-15
2006-08-31
2006-09-19
Spread, %
24- 6
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.
6
5
4
3
High grade
2
BB Bonds
High yield
1
0
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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
24- 7
Key to Bond Ratings
Moody's
Investment Grade
Aaa
Aa
A
Baa
Junk Bonds
Ba
B
Caa
Ca
C
McGraw Hill/Irwin
S&P's & Fitch
AAA
AA
A
BBB
BB
B
CCC
CC
C
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.
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
24- 8
Bond Ratings and Financial Ratios
Three years of median ratio data by bond rating
(2002– 2004).
Ratio
EBIT interest cover *
return on capital %
Total debt/capital %
AAA
23.8
27.6
22.9
AA
19.5
27
28.3
A
8
17.5
37.5
BBB
4.7
13.4
42.5
BB
2.5
11.3
53.7
B
1.2
8.7
75.9
CCC
0.4
3.2
113.5
* Earnings before interst and tax divided by interest
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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
24- 9
Bond Ratings and Default
Default rates of corporate bonds 1981-2005 by
S&P’s rating at time of issue
Rating at Time
of Issue
AAA
AA
A
BBB
BB
B
CCC
McGraw Hill/Irwin
Percentage Defaulting Within
1 Year after
5 Years after 10 Years after
issue
Issue
Issue
0
0
0
0.3
1.2
5.9
30.4
0.1
0.3
0.6
3.1
12.7
30.5
56
0.6
0.9
1.9
6.6
24
44.8
67.7
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24- 10
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.
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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
24- 11
Asset Value and Default
The market value of WorldCom assets, as default approached
90,000
80,000
70,000
Market value of assets
Value, $ millions
60,000
50,000
40,000
30,000
20,000
Default date
Default points
10,000
McGraw Hill/Irwin
02
7/
20
02
19
/0
/2
0
/6
10
3/
5/
20
02
02
28
/0
3/
20
02
/0
21
/0
2/
20
02
1/
20
01
15
7/
12
/2
0
01
/2
0
11
1/
27
/0
9/
20
01
0
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24- 12
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
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24- 13
Value at Risk (VaR)
Standard Measurements
 10 days
 10   day  10
 99% confidence interval
99%    2.33
 VaR
VaR  ( 10  2.33)  asset valu e 
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24- 14
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.
 10  .02  10
 6.32%
99%( )  .0632  2.33
 14.74%
VaR  .1473  10,000,000
 $1,473,621
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24- 15
Ratings Changes
Rating at end of year
Start of
year, %
AAA
AA
A
BBB
BB
B
CCC
AAA
92.08
0.62
0.05
0.03
0.03
0
0.1
McGraw Hill/Irwin
AA
7.09
90.83
2.09
0.21
0.08
0.08
0
A
0.63
7.76
91.37
4.1
0.4
0.27
0.29
BBB
0.15
0.59
5.79
89.38
5.53
0.34
0.58
BB
0.06
0.06
0.44
4.82
83.25
5.39
1.55
B
0
0.1
0.16
0.86
8.15
82.41
10.54
CCC
0
0.02
0.04
0.24
1.11
4.92
52.8
Default
0
0.01
0.05
0.37
1.45
6.59
34.14
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved