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Fin Distress
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7/21/2019 Fin Distress
http://slidepdf.com/reader/full/fin-distress 1/9
22/05/2015
1
Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Chapter 10:Credit Analysisand DistressPrediction
Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Key Concepts in Chapter 10
• The likelihood of financial distress is animportant aspect of firm risk.
• Numerous parties are interested in the credit-
worthiness of a company, including banks,investors, suppliers, auditors, and employees,among others.
• Debt is an important source of financing, thoughthere are trade-offs in financing with debtinstead of equity capital.
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Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Why Firms Use Debt Financing
• Interest tax shields
– Corporations or other taxable entities are able todeduct interest paid on debt as an ordinary businessexpense.
• Management incentive alignment
– Leverage imposes a discipline on management to
create value, reducing conflicts of interest betweenmanagers and shareholders.
Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Some Potential Downsides ofDebt Financing
• Increasing levels of debt financing may beaccompanied by higher a likelihood of financialdistress.
• Financial distress has some of the followingnegative consequences:
– Legal costs
– Damage to ability to raise capital
– Cost of conflicts between creditors and stockholders
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Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Median Leverage in Selected Industries
Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
The Market for Credit
• Commercial banks – May have better knowledge of a firm, but are
constrained in the amount of risk they can assume.
• Non-bank financial institutions – For example, savings & loans, insurance companies,
and investment bankers.
• Public debt markets – Requires that a firm have the size, financial strength,
and credibility to bypass the banking sector.
• Sellers who provide financing – Suppliers typically extend very short term financing to
buyers, but may occasionally grant a loan.
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Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Analyzing Credit
• Credit analysis is more narrowly focused than estimatingthe value of a firm’s equity.
• Business strategy, accounting, financial, and prospectiveanalyses are still important.
– The better a firm’s future business prospects, the lower the riskto the creditor.
• The steps a commercial lender might follow arepresented next. Note that they are interdependent.
Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
The Credit Analysis Process inPrivate Debt Markets
1. Consider the nature and purpose of the loan. – This helps with structuring the terms and duration of
the loan, along with the rationale for borrowing.
– The size of the loan must be set.
2. Consider the type of loan and availablesecurity.
– Numerous types of loans are available from openlines of credit to lease financing.
– The type and amount of security needed tocollateralize a loan must be established.
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Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
The Credit Analysis Process in
Private Debt Markets
3. Conduct financial analysis.
– Comprehensive analysis of business strategy,accounting, and financial aspects of the firm.
– Ratio analysis is useful, particularly ratiosaddressing the ability to make loan payments.
4. Assemble loan structure and debt covenants.
– Loan covenants specify mutual expectations of the
borrower and lender. – Some covenant terms include the borrower
maintaining specific financial conditions.
Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Financial Statement Analysis andPublic Debt
Debt ratings provide important information toinvestors
• The meaning of debt ratings: – Standard & Poor’s has a rating system from D to AAA
that grades the relative riskiness of debt.
– Debt ratings influence the yield that debt instrumentsmust pay for investors to buy them.
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Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
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Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Financial Analysis and Public Debt
• Factors that drive debt ratings:
– Performance measures are used to gauge theexpected future health of the firm and the ability torepay debt.
Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
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Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Prediction of Distress and Turnaround• Models for distress prediction
– Several models to predict distress have been developed over theyears. One of the more popular and robust models is theAltman’s Z-score model:
• Debt of distressed companies present investmentopportunities because they trade at steep discounts.
Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Z-Score Calculations for Wal-Mart and GM
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Copyright (c) 2008 Thomson South-Western, a part of theThomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Chapter 10: Credit Analysis andDistress Prediction
Palepu & Healy
Concluding Comments
• Debt financing offers tax savings and possiblereduction of agency costs to firms.
• The risk of financial distress increases with thelevel of debt financing.
• Credit analysis employs many of the same toolsused in business valuation, and is used by
issuers of debt, and investors.• Debt ratings are important information to
investors of public debt.