Credit Analysis and Distress Predictio

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Ch 10 – Credit Analysis and Distress Prediction
* The evaluation of a firm from the perspective of a (potential) holder of its debt WHY DO FIRMS USE DEBT FINANCING?
* Pros:
* Corporate tax shield: interest paid on debt is tax deductible * Management incentives for value creation: focuses management to generate cash flow to meet debt repayment and reduce unjustifiable expenses or investments that do no maximize shareholder value * Costs:

* Legal costs of financial distress: the direct costs of financial distress (i.e. lawyers, accountants, bankers) needed for restructuring * Costs of foregone investment opportunities: firms in distress are often unable to finance new investments even though they may be profitable for its owners * Costs of conflicts between creditors and shareholders: serving the interests of the shareholders will results in creditors raising cost of borrowing * Firms are more likely to fall into financial distress if they have high business risks, and intangible assets * As the firm becomes more highly leveraged, the costs of leverage will begin to outweigh the tax and monitoring benefits THE MARKET FOR CREDIT

Commercial Banks
* Provide a range of services to clients; have intimate knowledge of the clients which reduces the perceived riskiness of the credit. Credit risk can be contained through careful monitoring of the firm. * Banks have low risk tolerance to ensure quality of overall loan portfolio to comply with regulators * Banks also avoid any fixed rate with long maturities as it leaves them exposed to interest rate fluctuations. Banks can hedge these risks with derivatives or place the debt with investors. Non-Bank Financial Institutions

* S&L’s focus on financing mortgages
* Finance companies finance asset-based lending (i.e. secured financing of inventory, equipment, etc.) * Insurance companies often seek investments of long durations (i.e. commercial real estate development) * Investment bankers place debt securities with private investors or the public market * Government agencies

Public Debt Markets
* Firms of size, strength, and credibility can seek financing directly from investors via commercial paper or bonds * Banks often provide financing in tandem with a public debt issue * In an LBO, banks would provide financing at a much higher seniority that is scheduled for early retirement and carry a lower yield compared to the public debt) * For start-ups, banks would provide senior financing in conjunction with VC equity financing Sellers who Provide Financing

* Suppliers finance their customers’ purchases on a short term (30 to 60 days), unsecured basis * Longer financing periods can be negotiated, often with a secured note. THE CREDIT ANALSIS PROCESS IN PRIVATE DEBT MARKET

* Credit analysis is more than just establishing the creditworthiness of a firm (its ability to pay debts at scheduled times); the firm’s exact value, its upside potential, and distance from the threshold of creditworthiness are all equally important Step 1: Consider the Nature and Purpose of the Loan

* Important not only for deciding whether it should be granted but also for structuring the loan based on duration, purpose, and size (i.e. to finance an acquisition or working capital) * Banks like to be the sole, or at least most senior, financier for small- and medium-sized companies. Allows the bank to provide other financial services and maintain superior interest in the case of bankruptcy. * A firm that is a subsidiary of a parent firm, the firm that owns the assets that will be served as collateral acts as the borrower. The parent may still guarantee the debt. Step 2: Consider the Type of Loan and Available of Security

* The type of loan is a function of its purpose and the financial strength of the borrower * Open line of credit: permits the borrower to receive cash up to a specified...
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