Credit Analysis

Chapter 7 Credit Analysis

P7-1. Choice B is correct. As a company’s creditworthiness declines, investors’ required rate of return increases. The effect is to depress the market value of a company’s outstanding bonds. The book value of a firm’s bonds (or most liabilities), however, is not changed by the firm’s creditworthiness or other factors that affect the market value of the bonds according to U.S. GAAP.

P7-2. Choice A is correct. When bonds are issued at a discount, the firm will amortize a portion of the discount each year according to the effective interest rate method. Each period the firm’s recognized interest expense will exceed the cash outflow for the coupon payments made by the company. The carrying value of the bonds is augmented by the amount of discount that is amortized each period.

P7-3. Choice B is correct. Only the actual interest payments, not the full amount of interest expense, constitute a cash outflow. According to U.S. GAAP these interest payments are classified as operating cash outflows.

P7-4. Choice D is correct. For fiscal years beginning after 5/15/02, the gain (loss) on early extinguishment of debt is no longer classified as an extraordinary item. Also, the gain on repurchase of bonds does not constitute a cash inflow. In fact, the gain must be deducted from net income to arrive at operating cash flow.

P7-5. Choice C is correct. Differences in the debt covenants of two bond issues by the same firm can certainly result in substantial differences in ratings of these bonds by S&P. The other likely explanation, which is not among the choices listed, is that the firm’s financial condition deteriorated or improved markedly during this period.

P7-6. USOL reported a net income of $1.3 million Thus, its pre-tax income was 1.3 million/(1-.35) = $2 million To compute this firm’s EBITDA, one must also add back interest and depreciation expenses to pre-tax income: Pre-tax Income: $2 million Interest Expense: 5 million Depreciation: 3 million EBITDA: $10 million

EBITDA Coverage = EBITDA/Interest Expense = 2

In addition to examining the computation of this particular ratio, the problem also highlights the difference between EBITDA and net income (and free cash flow to equity holders). Even if this firm only makes investments in fixed assets equal to its depreciation expense and does not require any increase in working capital, its net income (and free cash flow to equity holders) is just $1.3 million (or just 13% of the reported EBITDA).

P7-10. A. Altman’s model would predict that a firm with these scores on the 5 variables of interest would go bankrupt. Its discriminant function (or Z)score {(.22X1.2)+(.15X1.4)+(.04X3.3)+(1.0X.6)+ (.58X1.0}=1.786 is less than 1.81. Firms with scores of this low magnitude were the most likely to go bankrupt. B. If the firm were the same in all respects but had a higher pre-tax return on average assets of .10 (rather than .04) then the firm would be classified as indeterminate by the model. Its Z-score would rise by (.06X3.3)=.198 giving it a total score of 1.984.

P7-11. While the Retained Earnings account does not constitute a reserve in any sense whatsoever, it does indicate the firm’s accumulated earnings since inception that have not been distributed to shareholders. As such, it represents a portion of the total equity of the firm; clearly, more is better. A higher ratio of retained earnings to total assets indicates that a greater portion of a firm’s total assets has been funded with equity in general, and with internally generated funds from earnings in particular. A higher ratio therefore implies successful previous operations and lower current leverage, all else being equal. Firms with these positive characteristics are less likely to experience financial distress.

P7-12 Operating leases indicate obligations for future outflows that are functionally the same as debt obligations and should be analyzed as such. For Magenta Air, the effective level of debt should be increased by $200 million; likewise, the assets that have been funded via operating leases are omitted from the balance sheet and must also be included. With these adjustments, MA’s debt-to-asset ratio is then:

$920 million or 0.83636 rather than the reported figure of $1.1 billion 0.8.

P7-15. MUNC’s business has not done well.

A. Long-term Debt = 500 million/400 million = 1.25 LTD + Equity

B. The foregoing data indicate that MUNC has a negative amount for total shareholders’ equity. This can only be achieved by means of an accumulated deficit in retained earnings. Thus, MUNC has lost a substantial amount of money (i.e., negative net income) in its first two years of operations. Case 7-1 Nortel – A New Chapter or Chapter 11?

1. According to the Z-Score there is a high risk of bankruptcy. Financial Variable Coefficient Nortel Data Weighted (Weight) Data (Current assets – current liabilities) / total 1.2 0.11 0.13 assets Retained earnings / total assets 1.4 -1.4 -1.96 Earnings before interest and taxes / total 3.3 -1.29 -4.25 assets Preferred and common stock market 0.6 1.47 0.88 value / book value of liabilities Sales / total assets 1.0 0.83 0.83 Total -4.37

2. Nortel has a current ratio of 11,762/9,457 or 1.24. This is above one, which is good. However, if Nortel’s customers are facing financial difficulties it calls into question their ability to buy new equipment or pay for equipment they have already received. It may be appropriate to apply a discount to reported inventory and receivables balances, beyond allowances already taken by the Company.

3. Nortel has $2.3 billion in liquidity (CA-CL), including debt that must be repaid in 2002. Additional debt maturities of $258 million in 2003 are the final significant maturities until 2006. Therefore, if Nortel can survive 2003 the risk of defaulting on its debt is reduced substantially.

Including the 2003 maturities, Nortel has $2.0 billion in remaining liquidity. Given its operating cash flow of $425 and capital expenditures of $1.3 billion this would last two years. By that time, the next debt maturities are far in the future, allowing the company to ride out difficult times. However, if business conditions worsen and Nortel is unable to match reduced operating cash flows with capital expenditure reductions the situation could become tenuous.