Probability of Default - Merton Model

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Question 1
With the use of Merton Model, the probability of Default (PD) of each firm is summarized as follow:

Company Name| ASX Code| Probability of Default|
Adelaide Brighton Limited| ABC| 0%|
Buderim Ginger Limited| BUG| 26.079%|
FFI Holdings Limited| FFI| 0.056%|
McPherson’s Limited| MCP| 0.003%|
Reece Australia Limited| REH| 0%|
Vietnam Industrial Investments Limited| VII| 2.472%|

Question 2
Using 15 Sep 2008 as a cut-off point, the pre and post results with respect to the Global Financial Crisis (GFC) analysis of PDs for the above 6 firms are summarized as follow: | | Probability of Defaults|

Company Name| ASX Code| 7 years| Pre GFC| Post GFC|
Adelaide Brighton Limited| ABC| 0%| 0%| 0%|
Buderim Ginger Limited| BUG| 26.079%| 21.716%| 11.693%| FFI Holdings Limited| FFI| 0.056%| 0.695%| 0%|
McPherson’s Limited| MCP| 0.003%| 0.012%| 0.056%|
Reece Australia Limited| REH| 0%| 0%| 0%|
Vietnam Industrial Investments Limited| VII| 2.472%| 17.319%| 5.313%|

Adelaide Brighton Limited (ASX Code: ABC)
The result shows that the probability of defaults for ABC remains constant at 0% both before and after the GFC.

Buderim Ginger Limited (ASX Code: BUG)
Before the GFC, the probability of default for BUG is 21.716%. After the GFC, the probability of default has reduced to approximately 11.693%.

FFI Holdings Limited (ASX Code: FFI)
Before the GFC, the probability of default for FFI is 0.695%. After the GFC, the probability of default has further reduced and reached 0%.

McPherson’s Limited (ASX Code: MCP)
Before the GFC, the probability of default for MCP is 0.012%. After the GFC, the probability of default has increased slightly to 0.056% Reece Australia Limited (ASX Code: REH)
The result shows that the probability of defaults for REH remains constant at 0% both before and after the GFC.

Vietnam Industrial Investment Limited (ASX Code: VII)
Before the GFC, the probability of default for VII is 17.319%. After the GFC, the probability of default has significantly reduced to 5.313%

Question 3
The probability of default (PD) of each firm can be influenced by both the firm and industry factors. The internal and external factors that may influence the probability of defaults of each firm will be discussed as follow:

a) Adelaide Brighton Limited (ASX Code: ABC)
The PDs for ABC remain constant at 0% both before and after the GFC. The low PD in ABC was mainly due to a high asset value but low asset volatility and liabilities of the firm, which increased the distance to default. The gearing ratio of ABC has significantly reduced from 55% in 2008 to only 16% in 2010 as a result of lowering debt level via capital raisings and cash management. Despite an increase in asset volatility from 24% before the GFC to 33% after the GFC, the significant low debt relative to the asset value has helped ABC to maintain a strong interest coverage ratio and share prices, hence a low PD.

b) Buderim Ginger Limited (ASX Code: BUG)
Before the GFC, the distance to default for BUG was less than 1 with a PD of 21.716% due to high asset volatility and total debts balance. The high total debts balance was resulted from the increase in borrowings for funding the acquisition project in 2008. The entire ginger industry has suffered from the GFC, together with strengthening of AUD and the severe drought condition, the total ginger revenue has declined. The drop in profit has reflected on the depreciation of share prices and the reduction in asset value. These impacts of these factors have been offset by the drop in asset volatility and debt reduction via capital raising, which has enabled BUG to achieve a low PD.

c) FFI Holdings Limited (ASX Code: FFI)
Despite the increase in total debts after the GFC, the rise in asset value was relatively larger than the rise in debts, together with the lowering of asset volatility, PD after the GFC has...
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