Principles of Corporate Finance Tenth Edition Chapter 23

24 - 2 Topics Covered Ø Yields on Corporate Debt Ø The Option To

Valuing Risky Bonds Example We have a 5% 1 year bond. The bond is

Valuing Risky Bonds Example – Continued Conversely - If on top of default risk,

Yield Spreads 12 10 Aaa Yield Spread, % Baa 8 High yield 6 4

2005 -04 -13 2005 -04 -28 2005 -05 -13 2005 -05 -31 2005 -06

Key to Bond Ratings The highest quality bonds are rated triple-A. Investment grade bonds

Bond Ratings and Financial Ratios Three years of median ratio data by bond rating

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

Credit Analysis Ø Credit analysis is only worth while if the expected savings exceed

24 - 11 Asset Value and Default Value, $ millions The market value of

Value at Risk (Va. R) Value at Risk = Va. R Ø Newer term

Value at Risk (Va. R) Standard Measurements Ø 10 days Ø 99% confidence interval

Value at Risk (Va. R) Example You own a $10 mil portfolio of IBM

Ratings Changes Mc. Graw Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc.

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

24 - 2 Topics Covered Ø Yields on Corporate Debt Ø The Option To Default Ø Bond Ratings and the Probability of Default Ø Predicting the Probability of Default Ø Value at Risk Mc. Graw Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved

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. 00 = expected CF Mc. Graw Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved 24 - 3

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: Mc. Graw Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved 24 - 4

Yield Spreads 12 10 Aaa Yield Spread, % Baa 8 High yield 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 Mc. Graw Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved 24 - 5

2005 -04 -13 2005 -04 -28 2005 -05 -13 2005 -05 -31 2005 -06 -15 2005 -06 -30 2005 -07 -18 2005 -08 -02 2005 -08 -17 2005 -09 -01 2005 -09 -19 2005 -10 -04 2005 -10 -20 2005 -11 -04 2005 -11 -22 2005 -12 -08 2005 -12 -23 2006 -01 -11 2006 -01 -27 2006 -02 -13 2006 -03 -01 2006 -03 -16 2006 -03 -31 2006 -04 -18 2006 -05 -03 2006 -05 -18 2006 -06 -05 2006 -06 -20 2006 -07 -06 2006 -07 -21 2006 -08 -07 2006 -08 -22 2006 -09 -07 Spread, % Credit Default Swap Data 3 2 Mc. Graw Hill/Irwin 24 - 6 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 High grade BB Bonds High yield 1 0 Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved

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. Mc. Graw Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved 24 - 7

Credit Analysis Ø 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. Mc. Graw Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved 24 - 10

24 - 11 Asset Value and Default Value, $ millions The market value of World. Com assets, as default approached Mc. Graw Hill/Irwin Default date Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved

Value at Risk (Va. R) Value at Risk = Va. R Ø Newer term Ø Attempts to measure risk Ø Risk defined as potential loss Ø Limited use to risk managers Factors Ø Asset value Ø Daily Volatility Ø Days Ø Confidence interval Mc. Graw Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved 24 - 12

Value at Risk (Va. R) Example You own a $10 mil portfolio of IBM bonds. IBM has a daily volatility of 2%. Calculate the Va. R over a 10 day time period at a 99% confidence level. Mc. Graw Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved 24 - 14