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Financial Statement Analysis

Financial Statement Analysis Contents

- Overview and objective of financial statement

analysis - Review and Re-formatting Statements for Financial

Analysis - Income Statement EBITDA and NOPLAT
- Cash Flow Statement - Free Cash Flow and Equity

Cash Flow - Financial ratio analysis
- Management Performance
- Valuation
- Credit Analysis
- Financial Model Drivers
- Reference Slides
- Financial Ratio Calculations
- Discussion of Economic Profit

Financial Statement Analysis - Introduction

- Financial Statement Analysis should tell a story

about the company How profitable is the

company, what are the trends, how much risk is

there etc. - You should be comfortable in reading various

different financial statements to be effective at

financial modeling and financial analysis. - Financial statement analysis is also important

in - Assessing management performance of a company

and whether projections of improvement or

sustainability are reasonable. - Assessing the value of a company from historic

performance. - Assessing the reasonableness of financial

projections provided by a company or the validity

of earnings projections - Assessing whether the financial structure of a

company is of investment grade quality

Objectives of Financial Statement Analysis

- Financial statement analysis is like detective

work How can we use information in financial

statements to make assessments of various issues.

The financials should paint a picture of what

has happened to the company - How can we quickly review the income statement,

balance sheet and cash flow statement to

determine how the stock market value of a company

compares to inherent value. - How can we look the financial statements and

assess risks associated with a company and

whether the company has sufficient cash flow to

pay off debt. - Finance and valuation are about projecting the

future -- how can financial statement analysis

be used in making projections. - The problem in any financial analysis and

valuation is that measuring risk is very difficult

Double Counting and Judgments in Financial Ratio

Analysis

- In analyzing financial statements judgments must

be made in computing key data such as EBITDA and

in developing financial ratios. - Examples
- Whether or not to include Other Income in EBITDA
- If other income not in EBITDA, then should not

add non-consolidated subsidiary companies in

invested capital - Exploration Expenses taken out of EBITDA
- Make consistent between companies with different

accounting policies - Goodwill (ROIC with or without goodwill depending

on analysis issue) - Minority Interest (if include or exclude do for

both income and balance) - Total of minority interest is in EBITDA,

therefore must include financing of minority

interest in invested capital - A key principle is that the financial data and

the financial ratios are consistent and logical

work through simple examples

Income Statement

Income Statement

- Review trends in EBITDA, EBIT, EBT and Net Income

and explain what is happening to the company - EBITDA includes operating earnings and other

income, but it does not include foreign exchange

gains or losses, minority interest, extraordinary

income or interest income. - EBITDA is a rough proxy for free cash flow
- EBITDA is not generally shown on Income Statement
- Potential Adjustments for items such as

exploration expense - Compare EBIT to Net Assets and Net Capital
- Ratio of EBITDA to Revenues should be shown for

historic and projected periods - EBITDA is related to un-levered cash flow while

Net Income and EPS are after leverage - NOPLAT is computed by EBIT less adjusted taxes,

where taxes are computed through adjusting income

taxes.

Standard Computation of EBITDA

Problems with EBITDA

- EBITDA is useful in its simplicity, and can be a

good reference for comparison of debt and value,

but it has weaknesses - EBIT is more important than DA, because must use

cash for replacing depreciation and amoritsation - In credit analysis, EBITDA works better for low

rated credits than high rated credits. (Moodys) - EBITDA is a better measure for companies with

long-lived assets - EBITDA can be manipulated through accounting

policies (operating expenses versus capital

expenditures) - EBITDA ignores changes in working capital, does

not consider required re-investment, says nothing

about the quality of earnings, and it ignores

unique attributes of industries.

Simplified Income Statement

- Sales- COGS
- Gross Margin- SGA- Other Expenses
- Other Income
- EBITDA
- - Depreciation and Amortization
- EBIT
- - Interest Expense (income)
- EBT- Income Taxes
- - Minority Interest
- Net Income
- NOPLAT EBIT x (1-tax rate)
- NOPLAT Net Income Interest Expense x (1-tax)

There is a debate about how to handle other

income from non-consolidated subsidiary

companies. One school of thought (McKinsey) is

that they should be valued separately since they

will have different cost of capital etc. In this

case, do not include in EBITDA and remove the

asset balance from the invested capital. Must be

consistent

Analysis of Income Statement Computation of

EBITDA, Minority Interest, Preferred Dividends,

Exploration Expense

Income Statement Analysis

- Example of Adjustments to EBITDA
- Exploration Expenses (EBITDAX)
- Rental and Lease Payments (EBITDR)
- EBITDA Computation
- Top Down move other income
- Bottom-up (Indirect)
- EBITDA Notes
- Interest Income out of EBITDA
- Interest Expense not in EBITDA
- Understand Non-cash Expenses
- Deferred Mining Costs
- Equity Income
- Minority Interest

Discounted Cash Flow Analysis Real World Example

- Credit Suisse First Boston estimated the present

value of the stand-alone, Unlevered, after-tax

free cash flows that Texaco could produce over

calendar years 2001 through 2004 and that Chevron

could produce over the same period. The analysis

was based on estimates of the managements of

Texaco and Chevron adjusted, as reviewed by or

discussed with Texaco management, to reflect,

among other things, differing assumptions about

future oil and gas prices. - Ranges of estimated terminal values were

calculated by multiplying estimated calendar year

2004 earnings before interest, taxes,

depreciation, amortization and exploration

expense, commonly referred to as EBITDAX, by

terminal EBITDAX multiples of 6.5x to 7.5x in the

case of both Texaco and Chevron. - The estimated un-levered after-tax free cash

flows and estimated terminal values were then

discounted to present value using discount rates

of 9.0 percent to 10.0 percent. - That analysis indicated an implied exchange ratio

reference range of 0.56x to 0.80x.

Employee Stock Options

- One can debate the treatment of employee stock

options for EBITDA, free cash flow and valuation. - Think of options as giving stock to employees
- If the treatment has changed over the years and

it is a significant expense, make adjustments to

current or prior statements for consistency. - Think of options as giving free shares to

employees. The value of existing shareholders is

diluted. - One can argue that this is two things
- First, employees are compensated and the cash

should be accounted for - Second, invested capital is increased and the new

equity should be included in the capital base

Cash Flow Statement

Cash Flow Statement

- Modern Cash Flow Statement has separation between
- Operations
- Capital expenditures (to maintain and grow

operations) and - Financing
- Operating Cash Flow
- Add back items from the income statement that do

not use cash (depreciation, dry hole costs etc) - Analyze how much cash flow the company generated

and how it raised funds or disposed funds - Use Cash Flow statement as a basis to compute

free cash flow although cash flow not presented

on the statement - Problem Interest Expense related to financing

and not operations is in the Net Income and is

included in Cash From Operations

Cash Flow Statement

- A. Operating Cash Flows
- 1) Net Income including interest expense,

interest income and taxes - 2) Depreciation
- 3) Deferred Taxes
- 4) Working Capital Changes
- 5) Minority Interest on Income Statement and

Other Items - B. Investing Cash Flows
- 1) Capital Expenditure and Asset Purchases
- 3) Sale of Property, Plant, Equipment
- 4) Inter-Corporate Investment
- C. Financing Cash Flows
- 1) Dividend Payments
- 3) Proceeds from Equity or Debt Issuance
- 4) Equity Repurchased
- 5) Debt Principal Payments

Cash Flow Statement Example

The Notion of Free Cash Flow

- In practice the term cash flow has many uses.

For example, operating cash flow is net income

plus depreciation. - Free cash flow is the cash flow that is available

to investors FREE of obligations such as

capital expenditures and taxes -- to both debt

and equity investors after re-investing in

plant, and financing and paying taxes. - Accountants define cash flow from operations as

net income plus depreciation and other non-cash

items less changes in working capital. However,

this cash flow is not available for distribution

to equity holders and debt holders. The free

cash flow must account for capital expenditures,

repayments of debt, deferred items and other

factors. - Free cash flow consists of
- Cash flow to equity holders
- Cash flow to debt holders

Theoretical Context Miller and Modigliani

- Theory that changed finance in 1958
- Value assets on fundamental operating

characteristics such as the capacity utilisation,

the cost and the efficiency of assets and not the

manner in which assets are financed debt versus

equity or the manner in which assets are hedged. - This has led to the discounted cash flow model

that underlies most valuations - The proof was based on a simple arbitrage idea

that you could buy stock in a company that has no

debt and then borrow against the stock. This

will yield the same results as if the company

borrowed money instead of you. - The implication of this is that project finance

is irrelevant

Fundamental Distinction in Financial Analysis

Free Cash Flow and Equity Cash Flow

- Free Cash flow that is independent from financing
- Valuation
- Performance in managing assets
- Claims on free cash flow
- Cash flow to pay debt obligations
- Comparisons unbiased by capital structure policy
- Equity cash flow
- Valuation of equity securities
- Performance for shareholders

Importance of Free Cash Flow

- Alternative Definitions, but one correct concept
- Free Cash Flow Is Also Known As Unleveraged Cash

Flow - Unleveraged Cash Flow Is Not Distorted By The

Capital Structure - Free Cash Flow should not change when the capital

structure changes - Free Cash Flow should be the same as equity cash

flow if no debt is outstanding and not cash

balances are built up. - Free Cash Flow in Valuation
- PV of Free Cash Flow Defines Enterprise Value
- The Relevant Discount Rate Is The Unlevered

Discount Rate or the Weighted Average Cost of

Capital - IRR on Free Cash Flow is the Project IRR
- Free Cash Flow in Economic Value
- FCF Carrying Charge Economic Profit

Cash Flow Statement in Financial Model

- Analysis in Cash Flow Statements
- Compute Cash Flow before Financing
- Operating Cash Flow minus Capital Expenditures
- Use Cash Flow Before Financing in Deriving Free

Cash Flow - Equity Cash Flow
- Dividends less Cash Investments
- Cash Flow Before Financing less Maturities plus

New Debt Issues - Last Line on Cash Flow Statement Includes
- Change in Cash Balance
- Change in Short-term Debt or Overdrafts
- Beginning Balance Change Ending Cash
- Beginning Balance of STD Change Ending

Short-term Debt

Free Cash Flow Formulas

- Free cash flow can be computed from the income

statement or from the cash flow statement. - From the cash flow statement, the formula is
- Cash Before Financing
- Plus Interest Expense
- Less Tax Shield on Interest
- From the income statement, the formula is
- EBITDA
- Less Taxes on EBIT
- Less Working Capital Investment
- Less Capital Expenditures
- From Net Income
- Net Income
- Add Net of Tax Interest
- Add Depreciation, Deferred Taxes and Other

Non-Cash Changes - Less Changes in Working Capital
- Less Capital Expenditures

Some argue that free cash flow should not include

non-operating items. Here the non-consolidated

companies are treated in a similar manner as

liquid investments

Free Cash Flow from NOPLAT

- Free cash flow can be computed using the notion

of net operating profit less adjusted tax as

follows (assuming no extraordinary income) - Step 1 Compute NOPLAT
- Net Income
- Plus Net Interest after Tax
- Plus Deferred tax
- Equals NOPLAT
- Step 2 Compute Free Cash Flow
- NOPLAT
- Plus Depreciation
- Less Change in Working Capital
- Less Capital Expenditures
- Equals Free Cash Flow

Free Cash Flow Example

One could make adjustments for dividends payable,

interest payable and other items in the working

capital analysis.

In actual situations, must adjust the free cash

flow for deferred tax

Balance Sheet

Balance Sheet Adjustments

- When analysing the balance sheet, various items

should be adjusted and grouped together - Net Debt
- Total short and long term debt minus liquid

investments held and surplus cash - Cash Bucket
- For modelling, subtract short-term debt from

surplus cash and liquid investments - Surplus Cash
- Include temporary investments and also include

long-term investments - Current Assets and Current Liabilities
- Separate the surplus cash from current assets and

the debt from current liabilities and relate

remaining working capital items to revenue and

expense items

Balance Sheet Issues

- Treat surplus cash as negative debt and debt as

negative cash - Rule of thumb cash is 2 of revenues
- Example when developing a basic cash flow

model, group the cash and the debt as one account

and then separate this account on the balance

sheet. - Unfunded pension expenses should be treated like

debt they involve a fixed obligation and they

can be replaced with debt when they are funded. - Deferred taxes depend on the way deferred taxes

are modelled for cash flow purposes. If you

model future changes in deferred taxes and take

account of these in projections, do not put

deferred taxes as a component of equity.

Problems with Equity Balance

- Would like the return on equity and the return on

invested capital to measure equity invested by

shareholders for return on investment and return

on equity - Problems with using equity balance on the balance

sheet to measure equity investment - Write-offs of plant
- Accumulated Other Comprehensive Income
- Goodwill
- Re-structuring losses
- Employee Stock options
- Can make adjustments to equity balance

Financial Ratio Analysis

Tension between Equity Analysis and Asset Analysis

- Free Cash Flow
- Project IRR
- ROIC (ROCE)
- WACC
- Enterprise Value
- EV/EBITDA
- Market to Replacement Cost

- Equity Cash Flow
- Equity IRR
- ROE
- Cost of Equity
- Market Capitalisation
- P/E
- Market to Book Ratio

EV S Value of Business Units Debt Equity

Value In ratio analysis, cash negative debt

IRR Mathematics and IRR Exercise

Why we raise to a power with two year case FV

PV (1r) (1r) FV PV (1r)2 FV/PV

(1r)2 (FV/PV)(1/2) (1r) (FV/PV)(1/2) 1

r

- IRR is simply rate of return
- Example Invest 100 and receive 120 in 1 year
- IRR 120/100 120 - 100 20
- If the cash flow is over two years
- IRR -100 , 60 , 60 ? 13.07
- Modified IRR with 5 Re-investment
- 60 receives 5 in year two ? 60 x (1.05) 63
- Plus final 60 123
- MIRR (123/100)(1/2) - 1 10.9

Financial Ratio Analysis

- Purpose
- Evaluate relation between two or more

economically important items (one is the starting

point for further analysis) - Cautions
- Accounting analysis is important (deferred taxes

etc.) - Interpretation is key
- What does the P/E mean
- Is an interest coverage of 3.5 good
- Why is the ROIC low
- Should we use MB, PE or EV/EBITDA
- Document financial ratios (numerator and

denominator) with footnotes and comments - Show components of numerator and denominator in

rows above the ratio calculation

General Discussion of Financial Ratios

- Financial Ratios Often Compares Income Statement

or Cash Flow with Balance Sheet - In developing ratios, understand why the formula

is developed (e.g. other income and other

investments in return on invested capital) - There is Not Necessarily One Single Correct

Formula - For example, pre-tax or after-tax return on

assets. - Keep the numerator consistent with the

denominator - Financial Ratios should be evaluated in the

context of benchmarks - Credit ratios and bond rating standards
- Returns and cost of capital
- Operating ratios and history

Classes of Financial Ratios

- Management Performance
- Ratios that measure the historic economic

performance of management and evaluate whether

the economic performance can be maintained (e.g.

ROIC) - Valuation
- Ratios that are used to give an indication of the

value of the company (e.g. P/E) - Credit Analysis
- Ratios that gauge the credit quality and

liquidity of the company (e.g. Interest coverage

and current ratio) - Model Evaluation
- Ratios used to evaluate the assumptions and

mechanics of financial forecasts

Ratios that Measure Management Performance

Class 1 Financial Indicators of Management

Performance

- Evaluate Whether Management is Doing a Good Job

with Investor Funds (Not if the company is

appropriately valued) - Return on Invested Capital
- Return on Assets
- Return on Equity
- Market/Book Ratio
- Market Value/Replacement Cost
- Key Issue
- Evaluate relative to risk
- ROE versus Cost of Equity
- ROIC versus WACC

ROIC, WACC and Growth

- ROIC is before interest and the return covers

both debt and equity financing EBIT is before

interest and investment includes both debt and

equity investment - WACC is the blended average of debt and equity

required returns - ROIC versus WACC measures the ability to make

true economic profit - Once have economic profit, should grow the

business as much as possible.

Basic Economic Principles, ROIC and Financial

Analysis

- When you measure value, you are gauging the

ability of a firm to realize economic profit.

For example, when you compare the equity IRR with

the equity cost of capital. - When you assess assumptions in a financial

forecast, you must assess whether economic profit

implicit in the assumptions can in fact be

realized. For example, if the financial forecast

has a very high ROE, is that reasonable. - When you interpret financial statistics, you are

gauging the strategy of the company in terms of

whether economic profit is being realized. In

reviewing the return on invested capital, does

this demonstrate that the company has the

potential to earn economic profit.

Return on Invested Capital Analysis

- ROIC is not distorted by the leverage of the

company - ROIC can be used to gauge economic profit and

whether the company should grow operations - ROIC can be used to assess the reasonableness of

projections - For example, if ROIC is very high and the company

is in a competitive business with few barriers to

entry, the forecast is probably not realistic. - ROIC can be computed on a division basis EBIT and

allocation of capital to divisions from net

assets to gauge the profit of parts of the

company - ROIC comes from sustainable competitive advantage

and high market share

Formula for Return on Invested Capital

- The return in invested capital formula can be for

a division or an entire corporation. It is after

tax and after depreciation. Cash balances should

be excluded from the denominator and interest

income from the numerator. Goodwill and goodwill

amortization should be excluded. - Formula
- ROIC EBITAT/Invested Capital
- Where
- EBITAT Earnings before Interest Taxes and

Goodwill Amortization less taxes on EBITAT - Taxes on EBITAT Cash Income Taxes Less Tax on

Interest Expense and Interest Income and Tax on

Non-operating Income - Invested Capital less cash balance
- Adjustments
- Other Assets
- Cash Balances
- Goodwill
- Other

Issues in Management Performance Evaluation

- Basic Formula ROIC versus WACC
- How to compute ROIC
- NOPLAT/Average Invested Capital
- May or may not include goodwill If goodwill is

not included, compute NOPLAT without subtracting

goodwill write-off and subtract net goodwill from

invested capital - Reduce the invested capital by surplus cash

balances - Some dont include other income then the

invested capital should be reduced by other

investments - Can compute with ratios
- EBIT Margin x (1-t) Asset Turn
- Asset Turn Sales/Assets EBIT Margin

EBIT/Sales - ROCE vs ROIC
- ROCE is generally computed in an indirect way by

starting with net income, and adding net of tax

interest and adding minorities

Exxon Mobil Return on Average Capital Employed

- Return on average capital employed (ROCE) is a

performance measure ratio. From the perspective

of the business segments, ROCE is annual business

segment earnings divided by average business

segment capital employed (average of beginning

and end-of-year amounts). - These segment earnings include ExxonMobils share

of segment earnings of equity companies,

consistent with our capital employed definition,

and exclude the cost of financing. - The corporations total ROCE is net income

excluding the after-tax cost of financing,

divided by total corporate average capital

employed. The corporation has consistently

applied its ROCE definition for many years and

views it as the best measure of historical

capital productivity in our capital intensive

long-term industry, both to evaluate managements

performance and to demonstrate to shareholders

that capital has been used wisely over the long

term. Additional measures, which tend to be more

cash flow based, are used for future investment

decisions.

Exxon Mobil Return on Capital Employed Where

are they making expenditures

Exxon Mobil Return on Capital

(1) All other financing costs net in 2003 includes interest income (after tax) associated with the settlement of a U.S. tax dispute.

Example of ROIC Calculation - AES

Illustration of Invested Capital Computation

ROE and ROIC Note how to compute growth rates

from ROE and Retention

Example of Return on Capital Employed (Return on

Invested Capital) in Financial Analysis

- The argument has been made that the best measure

to evaluate management performance that is not

distorted by leverage (as in the case of ROE) or

has the problems of ROA is the return on invested

capital. An example of use of this ratio is in

the Exxon Mobile Merger - J.P. Morgan reviewed and analyzed the return on

capital employed ("ROCE") of both Exxon and Mobil

since 1993. J.P. Morgan observed that Exxon's

ROCE has consistently been 2-3 above that of

Mobil. - J.P. Morgan's analysis indicated that if Mobil

were to be merged with Exxon, the combined

entity's capital productivity would eventually be

higher than the pro forma capital productivity of

Exxon and Mobil. - J.P. Morgan indicated that it would be reasonable

to assume that the benefits of this capital

productivity increase would occur within three

years of the closing of the merger.

Relationship Between Various Ratios and DuPont

Analysis

Asset Utilization

- Profitability

Working Capital/ Sales Plus Long-term capital/

Sales EqualsCapital employed/ Sales 1 divided by

Capital Employed/ Sales Equals Asset Turnover

(Sales/ Capital Employed)

Gross Margin Gross profit/ Sales Less

Operating costs/ Sales Equals EBIT Margin (EBIT/

Sales)

Multiplied by

ROCE(EBIT/ Capital Employed )

Multiplied by (1 minus Tax Rate)

ROCE(EBIT after Tax/ Capital Employed )

Class 2 Financial Indicators of Market Value

- Financial Ratios can be used to analyze whether

the valuation of a company is appropriate.

Analysts should understand the drivers of

different ratios. Valuation Ratios include - Universal Financial Ratios
- Price to Earnings Ratio
- Enterprise Value/EBITDA
- PEG (P/E to Earnings Growth) Ratio
- Market to Book Ratio
- Industry Specific Financial Ratios
- Value/Reserve
- Value/Customer
- Value/Plane Seat

Valuation Ratios and Benchmarks

- Valuation ratios measure the stock market value

of a company relative to some accounting measure

such as EPS, EBITDA, Book Value/Share or growth

in EPS - The ratios can be used as benchmarks in valuing

non-traded companies by using industry average

valuation ratios. - Example to value non-traded company
- Value of company EPS of Company x Industry

Average P/E Ratio - Valuation ratios will be further discussed in the

portion of the course where corporate models are

used to value companies.

P/E Ratio

- The P/E Ratio is the most prominent valuation

ratio. It is affected by estimated earnings

growth, the ability of a company to earn economic

profits and the growth in profitable operations. - Formula
- Share Price/Earnings per Share
- Issues
- Trailing Twelve Months and Forward Twelve Months

Generally use forward EPS - Formula (1-g/r)/(k-g)
- Problems
- Affected by earnings adjustments
- Causes too much focus on EPS
- Distortions created by financing

Illustration of EV Ratios and Computation of

Market Value of Balance Sheet Components

Investment Banker Analysis of Comparable Multiples

Investment Banker Analysis of Multiples

Use of PE in Valuation

- The long-run P/E ratio is often used in

valuation. This process involves - Project EPS
- Compute Stable EPS
- Compute P/E Ratio using formula
- P/E (1-g/r)/(k-g)
- g growth in EPS or Net Income
- r rate of return earned on equity
- k cost of equity capital
- Related Formula for terminal value with NOPLAT

(EBITAT) - (1-g/ROIC)/(WACC g)
- The formula demonstrates where value really comes

from

Risk Assessment of Debt and Analysis of Credit

Spreads

Liquidity and Solvency

Credit worthiness Ability to honor credit

obligations (downside risk)

- Liquidity
- Ability to meet short-term obligations
- Focus
- Current Financial conditions
- Current cash flows
- Liquidity of assets

- Solvency
- Ability to meet long-term obligations
- Focus
- Long-term financial conditions
- Long-term cash flows
- Extended profitability

Solvency Ratios

- Ratios are the center of traditional credit

analysis that assesses whether a company can

re-pay loans. These ratios should be compared to

benchmarks. - Solvency
- Debt Payback Ratios
- Funds from Operations to Total Debt
- Debt to EBITDA
- Leverage Ratios
- Debt to Capital (Include Short-term Debt)
- Market Debt to Market Capital
- Payment Ratios
- Interest Coverage
- Debt Service Coverage Cash Flow/(Interest

Principal) - Capital Investment Coverage
- Operating Cash Flow/Capital Expenditures

Liquidity

- Current Ratio
- Current Assets to Current Liabilities
- Current Assets less Inventory to Current

Liabilities - Model Working Capital
- Current Assets less Cash and Temporary Securities

minus Current liabilities less Short-term Debt - Liquidity Assessment
- Debt Profile (Maturities)
- Bank Lines (Availability, amount, maturity,

covenants, triggers) - Off Balance Sheet Obligations (Guarantees,

support, take-or-pay contracts, contingent

liabilities) - Alternative Sources of Liquidity (Asset sales,

dividend flexibility, capital spending

flexibility)

Banks or Rating Agencies Value Debt with Risk

Classification Systems

Map of Internal Ratings to Public Rating Agencies

SP Ratio Definitions

SP Benchmarks

Example of Using Ratios to Gauge Credit Rating

- The credit ratios are shown next to the achieved

ratios. Concentrate on Funds from operations

ratios.

Note that based on business profile scores

published by SP

Credit Rating Standards and Business Risk

Debt Capacity and Interest Cover

- Despite theory of probability of default and loss

given default, the basic technique to establish

bond ratings continues to be cover ratios,\.

Default Rates and Credit Spreads

Credit Spreads

Increase of 5

Credit Crisis

Moodys Forecast of Default Rates

Defaults versus Long-term Average

Moody's Speculative Grade Trailing 12-Month

Default Rates

Actual Jan. 2000 to Aug. 2002 / Forecasted Sept.

2002 to Feb. 2003

12.0

10.7

11.0

10.5

10.5

10.5

10.3

10.3

10.3

10.1

10.0

10.0

10.0

10.0

9.8

9.8

9.3

9.6

10.0

9.0

8.8

8.8

9.0

8.5

7.9

7.7

7.7

8.0

7.1

6.7

7.0

6.2

6.0

5.0

4.0

3.77

3.0

2.0

1.0

0.0

Jul-01

Jul-02

Jan-01

Feb-01

Mar-01

Apr-01

May-01

Jun-01

Oct-01

Jan-02

Feb-02

Mar-02

Apr-02

May-02

Jun-02

Oct-02

Jan-03

Feb-03

Aug-01

Sep-01

Nov-01

Dec-01

Aug-02

Sep-02

Nov-02

Dec-02

Months

Note Long run annual default rate is 3.77

Updated Transition Matrix

Probability of Default

- This chart shows rating migrations and the

probability of default for alternative loans.

Note the increase in default probability with

longer loans.

Bond Ratings and Historic Credit Spreads

Credit Spreads for Utility Debt

DSCR Criteria in Different Industries in Project

Finance

- Electric Power 1.3-1.4
- Resources 1.5-2.0
- Telecoms 1.5-2.0
- Infrastructure 1.2-1.6
- Minimum ratio could dip to 1.5
- At a minimum, investment-grade merchant projects

probably will have to exceed a 2.0x annual DSCR

through debt maturity, but also show steadily

increasing ratios. Even with 2.0x coverage

levels, Standard Poor's will need to be

satisfied that the scenarios behind such

forecasts are defensible. Hence, Standard

Poor's may rely on more conservative scenarios

when determining its rating levels. - For more traditional contract revenue driven

projects, minimum base case coverage levels

should exceed 1.3x to 1.5x levels for

investment-grade.

Credit Spread on Debt Facilities

- The spread on a loan is directly related to the

probability of default and the loss, given

default.

S

The Credit Triangle

S P (1-R)

P

R

- The credit spread (s) can be characterized as

the default probability (P) times the loss in

the event of a default (R).

Expected Loss Can Be Broken Down Into Three

Components

Borrower Risk

Facility Risk Related

EXPECTED LOSS

Probability of Default (PD)

Loss Severity Given Default (Severity)

Loan Equivalent Exposure (Exposure)

x

x

What is the probability of the counterparty

defaulting?

If default occurs, how much of this do we expect

to lose?

If default occurs, how much exposure do we expect

to have?

The focus of grading tools is on modeling PD

Comparison of PD x LGD with Precise FormulaCase

1 No LGD and One Year

- .

Comparison of PD x LGD with Precise FormulaCase

2 LGD and Multiple Years

- .

Default Rates by Industry

Recovery Rates

Mathematical Credit Analysis

General Payoff Graphs from Holding Investments

with Future Uncertain Returns

Payoff Graphs from Call Option Payoffs when

Conditions Improve

Payoff Graphs from Buying Put Option Returns

are realized to buyer when the value declines

Payoff Graphs from Selling Put Option Value

Changes with Value Decreases

The Black-Scholes/Merton Approach

- Consider a firm with equity and one debt issue.
- The debt issue matures at date T and has

principal F. - It is a zero coupon bond for simplicity.
- Value of the firm is V(t).
- Value of equity is E(t).
- Current value of debt is D(t).

Payoff to claimholders

At maturity date T, the debt-holders receive face

value of bond F as long as the value of the firm

V(T) exceeds F and V(T) otherwise. They get F -

MaxF - V(T), 0 The payoff of riskless debt

minus the payoff of a put on V(T) with exercise

price F. Equity holders get MaxV(T) - F, 0,

the payoff of a call on the firm.

Value of the company and changes in value to

equity and debt investors

Nominal Debt Repayment

Equity

F

Debt

V(T)

Value of Firm in Time T

Payoff to debt holders

Credit spread is the payoff from selling a put

option

A1

A2

Assets

B

The payoffs to the bond holders are limited to

the amount lent B at best.

Mertons Model

- Mertons model regards the equity as an option on

the assets of the firm - In a simple situation the equity value is
- max(VT -D, 0)
- where VT is the value of the firm and D is the

debt repayment required - Assumptions
- Markets are frictionless, there is no difference

between borrowing and lending rates - Market value of the assets of a company follow

Brownian Motion Process with constant volatility - No cash flow payouts during the life of the debt

contract no debt re-payments and no dividend

payments - APR is not violated

Mertons Structural Model (1974)

- Assumes a simple capital structure with all debt

represented by one zero coupon bond problem in

project finance because of amortization of bonds. - We will derive the loss rates endogenously,

together with the default probability - Risky asset V, equity S, one zero bond B maturing

at T and face value (incl. Accrued interest) F - Default risk on the loan to the firm is

tantamount to the firms assets VT falling below

the obligations to the debt holders F - Credit risk exists as long as probability (VltF)gt0
- This naturally implies that at t0, B0ltFe-rT

yTgtrf, where pTyT-rf is the default spread which

compensates the bond holder for taking the

default risk

Merton Model Propositions

- Face value of zero coupon debt is strike price
- Can use the Black-Scholes model with equity as a

call or debt as a put option to directly measure

the value of risky debt - Can use to compute the required yield on a risky

bond - PV of Debt Face x (1y)t
- or
- (1y)t PV/Face
- (1y) (PV/Face)(1/t)
- y (PV/Face)(1/t) 1
- With continual compounding - Ln(PV/Face)/t
- Computation of the yield allows computation of

the required credit spread and computation of

debt value - Borrower always holds a valuable default or

repayment option. If things go well repayment

takes place, borrower pays interest and principal

keeps the remaining upside, If things go bad,

limited liability allows the borrower to default

and walk away losing his/her equity.

Default Occurs at Maturity of Debt if V(T)ltF

Asset Value

VT

V0

F

Probability of default

Time

T

Resources and Contacts

- My contacts
- Ed Bodmer
- Phone 001-630-886-2754
- E-mail edbodmer_at_aol.com
- Other Sources
- Financial Library project finance case studies

including Eurotunnel and Dabhol - Financial Library Monte Carlo simulation

analysis