ACCT3013 Lecture Notes - Lecture 9: Yield Curve, Legal Expenses Insurance, Risk Aversion
NATALIE WU
1
ACCT3013 FINANCIAL STATEMENT ANALYSIS WEEK 9
Credit Analysis
Leverage and Credit Risk
• Equity Risk: the exposure to debt; the credit risk in servicing debt (interest payments) and the
repayment of principal capital when it falls due.
• Increased debt → increased risk because:
o Control of assets is passed on to creditors.
o Increased probability of failing to meet obligations.
o Increased probability of forced reorganisation or even bankruptcy.
• However, increased debt also provides opportunities for abnormal returns.
• Leverage can make or break wealth.
• Credit Risk: analysis of risk in leverage, and the likelihood of financial distress in servicing debt is
an important aspect of firm risk.
• Everybody works on credit today.
• Only creditors can initiate a bankruptcy claim, and shareholders absorb this risk through
investing.
• You can profit by trading on credit risk, by short-selling and identifying underperforming targets
for takeovers.
Suppliers of Credit
1. Public Debt Market Investors
• Includes long-term bondholders and short-term commercial paper holders.
• Sometimes packaged by banks into securitised debt obligations (SDOs) or collateralised
debt obligations (CDOs).
• CDO: combines cash-flow generating debt securities (loans, mortgages, bonds) and
repackages them into new products.
o Debt securities act as ‘collateral’ to the CDO product.
o Senior or prime CDO tranches have priority in repayment, thus lower risk and lower
expected return.
o Junior or sub-prime CDO tranches have higher risk and higher expected return, i.e.
there is a credit risk premium.
o By 2006, the CDO market grew so much that it even included non-investment grade
debts and gave the incentive to lenders to make sub-prime loans to anyone (even to
those with no income), thus fuelling demand of inflated house prices and the eventual
sub-prime crisis of 2007.
2. Commercial Banks
• Give loans to firms; must run a due diligence analysis of the firm’s ability to service debt.
• Banks are protected through debt covenants, where restrictions are imposed on company
operations and any further excessive financing that may lead to excessive credit exposure.
However, this also means that managers who choose to overexpose the firm to debt
effectively relinquish some of their control to debtholders at the expense of shareholders.
• Banks and investors are informed on the company’s ability to service debt by credit
analysts, especially those who work in credit rating agencies and issue credit health
warnings. In this way, the manager is disciplined: they must ensure that the firm can
always service its debt obligations with no perceived credit risk.
NATALIE WU
2
ACCT3013 FINANCIAL STATEMENT ANALYSIS WEEK 9
3. Other Financial Institutions, e.g. insurance companies and leasing firms, give finance but
typically must be secured by specific assets. Leasing requires access to debt.
4. Suppliers of Inventory, Operations and Utilities are creditors, especially when the company has
considerable bargaining power over its suppliers.
Credit Ratings
• The most influential credit rating agencies are Standard & Poor’s, Moody’s, and Fitch Ratings.
• Other regional agencies include Veda (Australia & NZ) and Dagong (China).
• Credit ratings rank firms according to their ability to repay debt.
• The ratings reflect:
1. The likelihood of default; and
2. The financial loss suffered in the event of default.
• Credit rating agencies are accredited by government, but should also be independent from the
government as they also issue ratings for public institutions and are a key source of legal
insurance.
• Ratings are used to monitor management and its ability to handle risk (especially credit risk).
• Ratings facilitate restrictions on investments, e.g. investment portfolios may require investing
only to investment-grade firms.
• Credit Ratings Controversy
o Credit ratings guide investment although their focus is strictly on ‘credit risk’ and place
little weight on the leverage effect of debt that causes profitability and growth.
o This suggests a risk-averse investment appraisal.
o Credit ratings agencies also overreact to bad news and underreact to good news, thus
exacerbating risk aversion.
o Credit ratings create downwards spirals: ratings downgrade → suggest higher risk →
higher cost of debt → lower ability to take in more finance → significant shrinkage →
lower ability to service debt → higher real risk → another ratings downgrade, etc.
o Ratings are incredibly inaccurate when it comes to big failures: they are incredibly slow to
pick up crises and default rates.
o They also offer services for improving credit rating outlook, hence leading to conflicts of
interest.
o Are supposed to be a source of legal insurance but agencies claim that ratings are ‘just
recommendations’ that should not be taken as facts.
Cost of Debt
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 = 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
• Creditors and potential creditors need to calculate the risk of servicing the loan (interest plus
repayment) in order to calculate the interest rate charged.
• For a creditor (lender), interest charged = rate of return.
• For a debtor (borrower), interest charged = cost of debt.
• Premium for risk of default is determined based on the ability of the business to service the
loan, sufficient collateral, and whether there are any restrictions in the debt covenant.
• Credit ratings can be used as measures for the credit risk premium to account for the
probability of default.
• Defined by the contracted interest rate.
• Fixed interest rates are predetermined, but variable rates must be forecasted to reflect
expectations (see yield curve).
Document Summary
Leverage and credit risk: equity risk: the exposure to debt; the credit risk in servicing debt (interest payments) and the repayment of principal capital when it falls due. Increased debt increased risk because: control of assets is passed on to creditors. Increased probability of forced reorganisation or even bankruptcy: however, increased debt also provides opportunities for abnormal returns, credit risk: analysis of risk in leverage, and the likelihood of financial distress in servicing debt is. Suppliers of credit: public debt market investors. In this way, the manager is disciplined: they must ensure that the firm can always service its debt obligations with no perceived credit risk. Acct3013 financial statement analysis week 9: other financial institutions, e. g. insurance companies and leasing firms, give finance but typically must be secured by specific assets. Leasing requires access to debt: suppliers of inventory, operations and utilities are creditors, especially when the company has considerable bargaining power over its suppliers.
