valuation of debt and debt like securities

© Grant Thornton LLP. All rights reserved.

Valuation of Debt and Debt-like Securities

Original Broadcast Date: September 2013

CPE Credit is not available for viewing archived programs.Please visit http://www.grantthornton.com/events for upcoming programs.

http://www.grantthornton.com/events

http://www.grantthornton.com/events

© Grant Thornton LLP. All rights reserved. 2

David DufendachPartnerValuation ServicesSeattle

Oksana WesterbekeManaging DirectorValuation ServicesBoston

John FerroManaging PartnerValuation ServicesNew York

Today'sPresenters


Valuation of Debt and Debt-like SecuritiesLearning objectives / Agenda

• Identify unit of account and its impact on the valuation

• Recognize different types of debt (straight debt, callable debt, convertible debt, debt-like preferred stock, etc.)

• Recognize the economics of each debt instrument and the value-driving factors

• Identify features of the debt instrument(s) that may require additional accounting and valuation considerations

• Identify methodologies to value various types of debt and embedded derivatives

• Recognize the driving factors behind the debt's credit rating

• List methodologies to develop a synthetic credit rating for the subject company and the subject debt

3


Valuation of Debt and Debt-like SecuritiesLearning objectives / Agenda (continued)

• List the pros and cons of each synthetic credit rating methodology

• Identify how to factor in debt's seniority, presence of collateral and third-party guarantee into the yield

• Recognize how to develop the market yield for the debt

7






• Identify features of the debt instrument(s) that may require additional accounting considerations

• Identify methodologies applicable to value various types of debt and embedded derivatives



5


Unit of account

• The unit of account defines what is being measured for financial reporting purposes. It is an accounting concept that determines the level at which an asset or liability is aggregated or disaggregated for purposes of applying ASC 820 or other ASC topic.

• The unit of account may be a standalone asset or liability, a group of assets, a group of liabilities or a group of assets and liabilities.


Unit of account and WACC

• Controlling interest

– For a controlling interest, market participant assumptions will include considerations of how an acquiring company can affect the capital structure and the required rates of return.

– Therefore, in estimating the weighted-average cost of capital ("WACC"), one should use market participant's assumptions about the capital structure and the cost of debt.


Unit of account and WACC (continued)

• Minority interest– For a minority interest, considerations about the optimal capital

structure are outside of the minority holders' control and their assumptions about capital structure are based on considerations of the company’s current situation (existing capital structure).

– Therefore, in estimating the WACC, one should use the subject company's capital structure and the cost of debt.

– However, for highly leveraged companies, market participants' capital structure and cost of debt would still be appropriate, as the expectation is that control shareholders will reduce the leverage to a normalized capital structure over time.


Unit of account and debt

• Controlling interest

– Since the definition of fair value under ASC 820 contemplates a transaction at the measurement date and, in most cases, the transaction in a controlling interest would necessarily require a repayment of all debt, the equity value is the proceeds remaining after settling the claims of debt holders.

– In this case, the principal market is the merger and acquisition market (considering the holder’s economic best interest). Therefore, one should subtract the payoff value of debt (including any change of control penalties) from the enterprise value in order to estimate the fair value of this controlling equity interest.


Unit of account and debt (continued)

• Minority interest– If the interest being valued is a minority equity interest that does not

have the ability to force a transaction for the entire business, the principal market is the sale of that minority interest in a private transaction.

– In this case, a market participant would not be able to restructure or otherwise extinguish the entity’s debt and would be subject to the continuing debt service requirements of the outstanding debt.

– To estimate fair value of a minority interest, current guidance indicates that one should subtract fair value of debt instead of book value. To the extent that the interest rate for the debt is different from the current market yield, the fair value of the debt will be different from its book value.


Treatment of debt based on fund holdings

Reporting entity controls equity

Reporting entity does not control equity

Equity securities Equity is estimated on a control basis using the payoff amount of debt

(including any prepayment penalties)

Equity is estimated on a minority basis using fair

value of debt

Debt (non-convertible) Payoff amount (including any prepayment

penalties)

Fair value










12


Debt basicsTerminology

• Indenture – contractual agreement stating terms of the debt• Issuer – entity that issues a bond certificate, borrows money, pays

interest, and repays principal. Issuer = borrower = subject company

• Holder – entity that holds a bond certificate, lends the money and receives interest and repayment of principal. Holder = lender = investors

• Principal – amount borrowed (also “par value” or “face value”)• Yield or coupon – interest that the issuer must pay• Maturity – date when principal must be fully repaid• Duration – a measure of the average life of a bond


Debt basicsCommon characteristics of debt

• Common characteristics or features– Publicly traded vs. private – Secured vs. unsecured– Senior vs. subordinated– Fixed rate vs. variable rate– Amortizing vs. non-amortizing– Cash paying vs. paid-in-kind (PIK)– Convertible vs. non-convertible– No enhancement vs. external third-party enhancement

(guarantee)


Debt basicsCommon types of debt

• Most common types of debt (or debt-like) instruments– Plain vanilla (straight) debt– Debt with early redemption options (puts and calls)– Convertible debt– Redeemable preferred– Debt in default– "Fresh start" debt


Types of debt and debt-like instrumentsPlain vanilla (straight) debt

• Debt that has a constant stated coupon and maturity

• Does not have early redemption options by either the issuer or the holder (calls or puts)

• Is not convertible

• Does not have any other contingencies

• Can be amortizable or PIK


Types of debt and debt-like instrumentsDebt with embedded options

• The issuer (holder) has the option to redeem debt at a pre-determined (contractually defined) value plus any accrued interest at predetermined (contractually defined) date(s)

• Party that holds the early redemption option is motivated to maximize the value of the asset held (or minimize the liability)

• Callable or putable debt has a variable rather than a contractual life: the value of the debt option is driven by the shape of the yield curve, yield volatility, the option nature of the call/put feature, and the "moneyness" of the call/put.

• Some debt may have make-whole provisions (similar to call options but much higher penalties)

• Embedded options make valuation of callable/putable debt challenging


Types of debt and debt-like instrumentsCallable debt

• Call is the early redemption (or prepayment) option held by the company

• The company has the option to call the security (or prepay the debt)

• Company is motivated to minimize its liability and will call the security when the fair value of debt is higher than the call value

• Company usually redeems debt prior to maturity if its cost of borrowing declined relative to the issuance date


Types of debt and debt-like instrumentsCallable debt (continued)

• A call option is an option held by the issuer (company). Therefore, to compensate investors for the risk of the company redeeming the debt, callable debt will have a higher coupon relative to comparable non-callable debt and/or lower value

• The call feature is generally effective over long periods of time (often throughout the life of the debt), but may have different call premiums throughout the life of the debt

• The call premium (or prepayment penalty) is also a consideration for the issuer when deciding whether to exercise the call option



• Example 1:– Company ABC (the Company) issued a 7-year 6.0%-coupon note on

12 December 2012 to a third party. The note is redeemable by the Company after the first anniversary at 100% of par.

• Example 2:– Company ABC (the Company) issued a 5-year 8.0%-coupon note on

10 October 2012 to a third party. The note is redeemable by the Company as follows:

• 103% of par anytime after the first anniversary• 102% of par anytime after the second anniversary• 101% of par anytime after the third anniversary• 100% of par anytime after the fourth anniversary



• If the market yield for the debt decreased either due to decreased credit risk of the company or the overall decline in the market spreads, then the company has incentive to call (prepay) the current high coupon debt and refinance at a lower rate

• The call option effectively puts a cap on the fair value of the debt

• This creates a negative convexity in the callable debt price – When yields are high and the call option is out-of-the-money, the

callable debt will behave very much like the straight debt – When yields are low and the call option is in-the-money, the call

option will limit the debt value to the call value


Types of debt and debt-like instrumentsCallable bond value as a function of market yields


Types of debt and debt-like instrumentsPutable debt

• Put is the early redemption option held by the security holder (the lender)

• The holder of the security (the lender) has the option to require the company to repay the debt at a certain predetermined price

• The holder is motivated to maximize the value of its asset (debt) and will put the security when the fair value is lower than the put value

• The holder usually redeems debt prior to maturity if the company's cost of borrowing has increased relative to the issuance date


Types of debt and debt-like instrumentsPutable debt example

• Example 1:

– Company ABC (the Company) issued a 6-year 5.0%-coupon note on 30 September 2012 to a third party.

– The note is redeemable by the holder at 100% of par on 30 September 2014 and 30 September 2016.


Types of debt and debt-like instrumentsPutable debt (continued)

• If the market yield for the debt increased, then the holders of the debt have incentive to put (require the company to repay) the current low coupon debt that no longer reflects the investment risk and refinance at a higher rate

• The put option effectively puts a floor on the fair value• A put option is an option held by the holder of the debt (investor or

lender). The lower risk of a putable debt is incorporated by way of a lower coupon (relative to comparable non-putable instruments) and/or higher value

• The put feature is generally effective on certain dates, for example, on the last date of each fiscal years 3, 4, and 5.

• It is common for the debt to have no put feature


Types of debt and debt-like instrumentsConvertible debt

• Hybrid instrument that contains features of both debt and equity• The conversion provision gives the debt holder the option to

convert its principal into a predetermined number of common shares at a predetermined price– When the conversion option is deep in the money, the instrument

behaves like equity– When the conversion option is deep out of the money, the instrument

behaves like debt– When the conversion option is near the money, the instrument

exhibits features of both debt and equity• May include early redemption features and/or other contingencies


Types of debt and debt-like instrumentsConvertible debt (continued)

• Always pays a coupon that is lower than an otherwise equivalent instrument without the conversion feature

• Valuation of a convertible debt requires sophisticated binomial lattice models

• In certain cases, when convertible debt has no early redemption options or other contingencies, the value of a convertible debt can be approximated using a DCF method for contractual debt payments and a Black-Scholes call option model to value the conversion option


Types of debt and debt-like instrumentsMandatorily redeemable preferred stock

• Preferred equity that pays dividends but has no conversion feature or participation rights with equity

• Similar to straight debt from a valuation perspective– Redeemable preferred dividends ≈ Debt coupon

• Key differences from debt– Preferred stock has no predetermined maturity date (perpetual)– Has a mandatory redemption date– Lower in capital structure– Non-payment of dividends is usually not considered a default by the

issuer– Different accounting treatment


Types of debt and debt-like instrumentsDebt in default

• Debt in default– Non-payment of interest and/or principal when due– Broken covenants

• Typically valued based on the following methodologies– Liquidation analysis

• Valuation of individual assets and/or total enterprise value• Given priority to claims that rank senior to the subject debt

– Going concern (restructuring) analysis• Based on the company’s restructuring plan and ability to repay debt

– Expected value analysis• Based on liquidation and negotiation scenarios


Types of debt and debt-like instruments"Fresh start" debt

• Debt issued by companies emerging from bankruptcy

• Typical characteristics– Secured– Medium term– High cash coupon

• Valuation challenges– Difficult to assess credit rating– Past is not representative of the future– Information about the future is often withheld and/or unavailable– Difficult to find comparable fresh start debt










31


Key drivers of debt value

Debt value

Company- specific factors

Instrument- specific factors

Market factors


Key drivers of debt valueCompany-specific factors

• Credit risk (also “default risk” or “nonperformance risk”)

• Risk of loss arising from borrower’s inability to fulfill contractual obligations of the debt agreement

• Uncertainty surrounding underlying cash

flows of debt instruments• Credit loss manifests itself through…

– Unpaid principal and/or interest– Decreased cash flow– Delayed timing of cash flows– Increased costs (e.g., collection costs, legal

costs)

Debt value

Company specific factors

Instrument specific factors

Market factors


Key drivers of debt valueCompany-specific factors that affect credit risk

• Quantitative considerations– Size– Leverage– Interest coverage– Solvency– Profitability– Operating performance

• Qualitative factors– Management expertise– Industry dynamics and competition– Overall operating and financial performance

Debt value



Market factors


Key drivers of debt valueCompany-specific factors that affect country credit risk

• Two-step process for foreign debt

1. Consider credit risk of domicile country

2. Consider credit risk of issuing company

Debt value



Market factors


Key drivers of debt valueInstrument-specific factors

• Coupon• Seniority• Collateral• Maturity/duration• Structure (e.g., embedded options,

paid-in-kind interest)• Covenants• Amortization schedule• Credit enhancements

Debt value



Market factors


Key drivers of debt valueMarket factors

• Market and other external factors

• Benchmark rates (e.g. U.S. Treasurys)

• Market liquidity

• Market shocks (e.g., financial crisis)

• General economic environment

• Regulatory environment

Debt value



Market factors


Key drivers of debt valueImpact of certain factors on debt value

Factor group Factor Lower value Higher value

Company-specific Credit Poor credit Excellent credit

Instrument-specific Collateral Unsecured Secured

Seniority Subordinated Senior

Maturity / duration Longer Shorter

Coupon Paid-in-kind Cash

Covenants No covenants Covenant-heavy

Embedded options Callable by issuer Putable by holder

Principal amortization Non-amortizing Amortizing

Market factor Benchmark rates Increasing Decreasing

Market yields Increasing Decreasing

Liquidity Illiquid Very liquid










39


Embedded optionsThings to watch out for

• Conversion options if: (i) upon conversion, holders can receive cash or a combination of cash and shares or (ii) the number of shares authorized is not sufficient to meet the company's obligations under the conversion option

• Redemption option held by the holders if it is contingent upon certain events (other than a change of control event), such as loss of major customer, etc.

• Redemption option held by the company if it is linked to the next round of equity financing. For example, company can redeem a portion or 100% of the notes with the proceeds from a qualified round.


Embedded optionsThings to watch out for (continued)

• Contingent interest (interest increase or interest resets if certain conditions are met)

• Beneficial conversion features if the note's conversion option is believed to be in-the-money on the issuance date

• Beneficial conversion features upon an IPO if debt converts at a discount to the IPO price

• Default provisions, such as: (i) redemption option held by noteholders to put the debt upon a default event, (ii) default penalties, or (iii) default (higher) interest rate










42


Valuation approachesThe Yield Method

• Discounted cash flow (DCF) analysis that discounts contractual cash flows (principal and interest payments) using a risk-adjusted discount rate (market yield)

• All risk factors associated with the debt are captured in the discount rate• Most commonly used methodology to value debt• Easy to apply• Most applicable when…

– Valuing performing debt (covenants are not broken, debt is not in default)– Debt has no early redemption options or other contingencies

• Key steps– Calculate and model contractual interest and principal payments– Estimate a discount rate indicative of a market yield– Discount the adjusted cash flows to the measurement date


Valuation approachesThe Yield Method (continued)

• Potential valuation challenges

– Estimating appropriate discount rates when market data may be unavailable (e.g., CC rated debt or foreign debt)

– Adjusting yields/spreads when there are no closely comparable debt issuances with observable yields (e.g., different seniority or collateral provisions)

– Considerations for a floating or PIK nature of the coupon


Valuation approachesThe Yield Method (continued)

Significant assumptions Market yield analysis

Valuation Date 3/31/2013 Credit rating CCCFirst coupon date 6/30/2013 Credit rating source Ordered Logit ModelMaturity date 10/21/2016 Credit rating date 4/16/2013Term (years) 3.56 Spread 856Notional outstanding 70,000Coupon type FixedCoupon margin 8.00% Value using the Yield Method 68,925Months between reset dates 6.00 Value as % of par 98.5%

PeriodPayment

date

Beginning principal balance

Principal repayments

Ending principal balance

Interest payment

Total cash flow (principal plus

interest) Discount rateDiscount

factorPresent value of cash flows

1 6/30/2013 $70,000 5,000 $65,000 1,416 6,416 9.00% 0.98 6,2792 12/30/2013 65,000 5,000 60,000 2,643 7,643 9.00% 0.94 7,1653 6/30/2014 60,000 5,000 55,000 2,427 7,427 9.00% 0.90 6,6684 12/30/2014 55,000 5,000 50,000 2,237 7,237 9.00% 0.86 6,2245 6/30/2015 50,000 5,000 45,000 2,022 7,022 9.00% 0.82 5,7856 12/30/2015 45,000 5,000 40,000 1,830 6,830 9.00% 0.79 5,3897 6/30/2016 40,000 5,000 35,000 1,627 6,627 9.00% 0.76 5,0088 10/21/2016 35,000 35,000 0 879 35,879 9.00% 0.74 26,406


Valuation approaches Binomial lattice model

• When debt has embedded conversion, call or put features, the debt has a variable rather than a contractual life as it can be converted/called/put, and, therefore, terminate before the maturity date is reached

• The value of the debt with embedded conversion option is driven by the expectations about the distribution of future stock prices, which is a function of the stock volatility, and "moneyness" of the conversion option

• The value of the debt with embedded call or put option is driven by the shape of the yield curve

• The appropriate methodology to value callable/putable debt is a binomial lattice model


Valuation approaches Binomial lattice model (continued)

• Most applicable when…

– Valuing debt with the embedded call or put option


– Requires a sophisticated valuation model that explicitly models all embedded features of the debt

– Generally, difficult to implement in-house; requires valuation specialist


Valuation approachesBlack-Derman-Toy (BDT) model

• As the value of the debt with embedded call or put option is driven by the shape of the yield curve, in the valuation of callable or putable debt, one should develop the binomial tree of future interest rates.

• There are several methodologies to develop the interest rate tree. One of the most commonly used methodologies is Black-Derman-Toy ("BDT") model

• BDT model assumes that interest rates follow a binomial process and uses current observed yields and yield volatility to estimate future outcomes for the yields


Valuation approachesBlack-Derman-Toy (BDT) model (continued)

Example:

ABC Company issued debt to third party at 100% of par on 12/31/2012. The debt has a 7% coupon paid annually and maturity of 5 years. The debt is prepayable (callable by the company) at 100% of par at anytime.

• If interest rates decline, the value of the debt will increase as debt is paying a higher coupon than a newly issued callable debt would (at lower market yield)

• The company will choose to minimize its liability (not let the value increase above par) and repay the debt to refinance at lower interest rates



• First 10 nodes of a sample binomial interest rate tree

0 1 2 3 4 5 6 7 8 9 10Date 12/31/2012 1/4/2013 1/8/2013 1/13/2013 1/17/2013 1/21/2013 1/26/2013 1/30/2013 2/4/2013 2/8/2013 2/12/2013

Time (years): 0.00 0.01 0.02 0.04 0.05 0.06 0.07 0.08 0.10 0.11 0.12

Volatility 31.50% 31.50% 31.50% 31.50% 31.50% 31.50% 31.50% 31.50% 31.50% 31.50% 31.50%

0.00 5.12% 4.95% 4.78% 4.61% 4.45% 4.30% 4.15% 4.01% 3.87% 3.74% 3.61%0.01 5.30% 5.12% 4.94% 4.77% 4.61% 4.45% 4.30% 4.15% 4.00% 3.87%0.02 5.48% 5.29% 5.11% 4.94% 4.77% 4.60% 4.44% 4.29% 4.14%0.04 5.67% 5.48% 5.29% 5.11% 4.93% 4.76% 4.60% 4.44%0.05 5.87% 5.67% 5.47% 5.28% 5.10% 4.93% 4.76%0.06 6.07% 5.86% 5.66% 5.47% 5.28% 5.10%0.07 6.28% 6.06% 5.86% 5.65% 5.46%0.08 6.50% 6.27% 6.06% 5.85%0.10 6.72% 6.49% 6.27%0.11 6.95% 6.72%0.12 7.19%



• Call feature caps the value of the debt on the high nodes of the binomial tree, reducing the value of the debt

Period 0 1 2 3 4 5 6 7 8 9 10Date 12/31/2012 1/4/2013 1/8/2013 1/13/2013 1/17/2013 1/21/2013 1/26/2013 1/30/2013 2/4/2013 2/8/2013 2/12/2013Time 0.00 0.01 0.02 0.04 0.05 0.06 0.07 0.08 0.10 0.11 0.12

Accrued interest 0.00 0.08 0.15 0.25 0.33 0.40 0.50 0.58 0.67 0.75 0.82Callable as % of par 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

0.00 100.00 100.08 100.15 100.25 100.33 100.40 100.50 100.58 100.67 100.75 100.820.01 100.08 100.15 100.25 100.33 100.40 100.50 100.58 100.67 100.75 100.820.02 100.13 100.25 100.33 100.40 100.50 100.58 100.67 100.75 100.820.04 100.14 100.29 100.40 100.50 100.58 100.67 100.75 100.820.05 100.11 100.31 100.47 100.58 100.67 100.75 100.820.06 100.05 100.29 100.49 100.64 100.75 100.820.07 99.96 100.23 100.47 100.66 100.810.08 99.83 100.14 100.41 100.640.10 99.67 100.01 100.320.11 99.48 99.860.12 99.26



• Value for identical bond without the call feature

Period 0 1 2 3 4 5 6 7 8 9 10Date 12/31/2012 1/4/2013 1/8/2013 1/13/2013 1/17/2013 1/21/2013 1/26/2013 1/30/2013 2/4/2013 2/8/2013 2/12/2013Time 0.00 0.01 0.02 0.04 0.05 0.06 0.07 0.08 0.10 0.11 0.12

Accrued interest 0.00 0.08 0.15 0.25 0.33 0.40 0.50 0.58 0.67 0.75 0.82Callable as % of par - - - - - - - - - - -

0.00 101.55 101.83 102.10 102.35 102.58 102.80 103.01 103.21 103.39 103.57 103.730.01 101.39 101.69 101.96 102.22 102.47 102.70 102.91 103.12 103.31 103.490.02 101.23 101.53 101.82 102.10 102.35 102.59 102.81 103.03 103.230.04 101.05 101.37 101.67 101.96 102.23 102.48 102.71 102.930.05 100.86 101.20 101.51 101.81 102.09 102.35 102.600.06 100.65 101.01 101.35 101.66 101.95 102.230.07 100.44 100.81 101.17 101.50 101.800.08 100.21 100.61 100.98 101.320.10 99.97 100.38 100.770.11 99.71 100.150.12 99.44


Valuation approachesRecovery analysis

• DCF analysis of cash flows estimated based on the net recoverable proceeds resulting from the liquidation of the underlying asset(s)

• There might be one or more scenarios• Also called Net Realizable Value method• Most applicable when…

– Valuing non-performing or defaulted debt– Cash flows are no longer expected in accordance with contractual terms

• Key steps– Estimate gross proceeds from the underlying asset(s) using an estimated recovery

assumption (based on comparable market and/or historical data) or from a direct appraisal of the underlying asset

– Adjust gross recovery proceeds based on servicing, legal, collection, and other costs incurred in liquidating the underlying asset(s)

– Estimate a discount rate to apply to the net recovery cash flows– Discount the net proceeds over an appropriate recovery period


Valuation approachesRecovery analysis (continued)


– Estimating a gross recovery rate or the value of the underlying asset(s)

– Identifying and quantifying additional costs/expenses required to calculate net proceeds

– Estimating the recovery period

– Estimating a risk-adjusted discount rate that appropriately captures the risk inherent in the non-performing debt


Valuation approachesSummary

Valuation approach Types of debtThe Yield Method Performing debt

“Straight” debt

Mandatorily redeemable preferred stock

Convertible debt

Debt with embedded call/put options

Recovery analysis Non-performing / distressed debt

Debt in default

Lattice model with an interest rate tree (e.g. BDT Model)

Lattice model with a price tree








7


Credit rating

• One of the most critical steps in estimating the fair value of debt• Drives the selection of the comparable debt universe, applicable

spread and/or recovery rate• When the actual credit rating is not available for the subject

company and/or subject debt, one can estimate a "synthetic" credit rating

• Steps prior to proceeding:– Make sure the subject debt is not traded

• Check Bloomberg TRACE data• Cannot rely on BVAL or BGN Bloomberg rating system

– Make sure the subject company does not have other traded debt from which the market yield for the subject debt can be derived

– Make sure the company does not have a corporate or debt rating


Credit ratingQuantitative methodologies

• Linear regression analysis on one or more key financial metrics

• Damodaran rating system

• Moody’s credit rating tool for private companies

• Ordered Logit Model (distribution of ratings)

NOTE: All the above methodologies estimate the subject company's credit rating, not the specific debt credit rating


Credit ratingQuantitative methodologies (continued)

• Gather ratings and financial data for a universe of rated companies– Larger universe (all US rated companies, excluding certain

industries, such as financial services and utilities)– Industry-specific (smaller sample size that captures a scale of

available ratings)

• Assess the relationship between the financial metrics for the universe of companies and their respective credit ratings

• Estimate a corporate credit rating for the subject company based on the estimated relationship and the subject company’s financial metrics


Regression analysisSummary

• Credit rating is regressed against one or more financial metrics• Metrics typically considered:

– Size (log) of total assets (formula = LN(Total Assets))– Debt to total asset ratio– Debt to market cap– Interest coverage ratio (interest expense excluding interest income

divided by EBIT)– Industry-specific factors (financial services)

• Each relationship between the financial metric and the rating is assessed individually. Results are then compared and one rating or a range of ratings is selected.


Regression analysisPros and cons

Pros:• Easy to understand• Easy to use• Can see the magnitude of rating's dependency on a certain metric

(R square)

Cons:• Statistical tool is often required to perform a multi-variable

regression analysis• Single variable regressions often result in vastly different credit

ratings (A to CCC)• Hard to narrow down on a rating• Does not show a distribution of rating (gives you only one rating)


Damodaran credit rating methodologySummary

• Assesses credit rating based on interest coverage ratio

• Damodaran developed a matrix relating company's interest coverage ratio to its credit rating for three universes:– Large manufacturers– Financial services– Small and risky companies

• Latest spreadsheet is available for download at http://people.stern.nyu.edu/adamodar/


Damodaran credit rating methodologyExample

Inputs for synthetic rating estimationPlease read the special cases worksheet (see below) before you use this spreadsheet.Before you use this spreadsheet, make sure that the iteration box (under calculation options in excel) is checked.Enter the type of firm = 2 (Enter 1 if large manufacturing firm, 2 if smaller or riskier firm, 3 if financial service firm)Small: <$5 billion

Do you have any operating lease or rental commitments? YesEnter current Earnings before interest and taxes (EBIT) = 50 (Add back only long term interest expense for financial firms)

Enter current interest expenses = 8 (Use only long term interest expense for financial firms)

Enter current long term government bond rate = 5.10%

Output

Interest coverage ratio = 2.91

Estimated Bond Rating = B+ Note: If you get REF! All over the place, set the operating lease commitment question in cell F5Estimated Default Spread = 5.50% to No, and then reset it to Yes. It should work.Estimated Cost of Debt = 10.60%

If you want to update the spreads listed below, please visit http://www.bondsonline.com

For large manufacturing firms For financial service firms (default spreads are slighty different)If interest coverage ratio is If long term interest coverage ratio is

> ≤ to Rating is Spread is greater than ≤ to Rating is Spread is-100000 0.199999 D 12.00% -100000 0.049999 D 12.00%

0.2 0.649999 C 10.50% 0.05 0.099999 C 10.50%0.65 0.799999 CC 9.50% 0.1 0.199999 CC 9.50%0.8 1.249999 CCC 8.75% 0.2 0.299999 CCC 8.75%1.25 1.499999 B- 7.25% 0.3 0.399999 B- 7.25%1.5 1.749999 B 6.50% 0.4 0.499999 B 6.50%1.75 1.999999 B+ 5.50% 0.5 0.599999 B+ 5.50%

2 2.2499999 BB 4.00% 0.6 0.749999 BB 4.00%2.25 2.49999 BB+ 3.00% 0.75 0.899999 BB+ 3.00%2.5 2.999999 BBB 2.00% 0.9 1.199999 BBB 2.00%3 4.249999 A- 1.30% 1.2 1.49999 A- 1.30%

4.25 5.499999 A 1.00% 1.5 1.99999 A 1.00%5.5 6.499999 A+ 0.85% 2 2.49999 A+ 0.85%6.5 8.499999 AA 0.70% 2.5 2.99999 AA 0.70%8.50 100000 AAA 0.40% 3 100000 AAA 0.40%


Damodaran credit rating methodologyExample (continued)

For smaller and riskier firmsIf interest coverage ratio isgreater than ≤ to Rating is Spread is

-100000 0.499999 D 12.00%0.5 0.799999 C 10.50%0.8 1.249999 CC 9.50%1.25 1.499999 CCC 8.75%1.5 1.999999 B- 7.25%2 2.499999 B 6.50%

2.5 2.999999 B+ 5.50%3 3.499999 BB 4.00%

3.5 3.9999999 BB+ 3.00%4 4.499999 BBB 2.00%

4.5 5.999999 A- 1.30%6 7.499999 A 1.00%

7.5 9.499999 A+ 0.85%9.5 12.499999 AA 0.70%12.5 100000 AAA 0.40%


Damodaran credit rating methodologyPros and cons

Pros:• Easily available• Free• Easy to use (gives you rating and yield)

Cons:• Based on the market that is dominated by larger industry players• Implies that interest coverage ratio has the largest impact on the credit

rating• Only current matrix is available (no historical data)• Historically, was indifferent to the company size:

– Underestimated rating for larger companies– Overestimated rating for smaller companies– Now uses a separate table for "smaller, riskier" companies


Moody's credit rating toolOverview

Online tool to assess the credit rating based on various company metrics

Pros:• Developed by Moody's• Considers various factors

Cons:• Not very widely used• Requires pay for subscription• Needs to be calibrated to adjust the synthetic credit rating based

on the error margin observed (additional work)• Based on past cases, it was, on average, 3 notches (a full rating)

off


Ordered Logit ModelOverview

• Ordered Logit ("oLogit") model*– Five independent ("X") variables (factors):

* Based on paper “A Methodology for Estimating Credit Ratings and the Cost of Debt for Business Units and Privately Held Companies,” Minardi, Sanvicente, Artes.

Factor Metric Impact on credit rating

Size Total assets Significant

Leverage Debt / Total assets Significant

Solvency EBIT / Debt Marginal

Operating performance Return on assets Minimal

Operating margin EBIT/Revenue Minimal


Ordered Logit ModelNumeric variables

• Dependent ("Y") variable is a categorical variable that is ordered• Model output is on an ordinal scale corresponding to the different

S&P credit ratings.

S&P rating Numeric rating S&P rating Numeric rating

AAA 1 BB 12

AA+ 2 BB- 13

AA 3 B+ 14

AA- 4 B 15

A+ 5 B- 16

A 6 CCC+ 17

A- 7 CCC 18

BBB+ 8 CCC- 19

BBB 9 CC 20

BBB- 10 C 21

BB+ 11 D 22


Ordered Logit ModelMechanics

• The Ordered Logit model establishes a relationship between credit ratings and financial data of guideline companies and estimates coefficients for each financial variable

• Once relationship is established, user inputs subject company’s financial data

• Ordered Logit estimates the probability of that company being assigned each of the 22 different credit ratings

• Rather than specifying a predicted value (or rating), the model provides a distribution across credit ratings

• The synthetic credit rating falls within the range of credit ratings with the highest estimated probabilities


Ordered Logit ModelExample of distribution

• In this example, the model estimated a synthetic credit rating in the range of B+ to B- for this particular company

0.2% 0.5% 0.7% 0.9%2.3%

8.1%

17.9%

29.4%

32.8%

6.4%

0.8%0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CC

Pe

rce

nt

Rating

Credit Rating Distribution


Ordered Logit ModelExample of output from Grant Thornton oLogit model

Subject Company Financials Subject Company Ratios

Total assets $9,172.1 Natural Logarithm of total assets 9.12

Total debt 774.5 Debt ratio 0.08

Revenues 24,864.3 EBIT / Total debt 3.75

EBIT 2,904.4 Return on assets 0.19

Net income 1,777.2 EBIT margin 0.12

Credit Category Probabilities

AA and above 9.18%

A+ 9.61%

A 18.29%

A- 16.45%

BBB+ 17.94%

BBB 15.58%

BBB- 5.95%

BB+ 2.73%

BB 1.94%

BB- 1.24%

B+ 0.72%

B 0.31%

B- 0.05%

CCC+ and below 0.02%

Quantitative Credit Rating A


Comparison of results

• Grant Thornton tested several methodologies to estimate the synthetic credit rating

• Grant Thornton selected 10 random companies to represent good cross section of the universe

• Tested dependability of the credit rating:– Size of assets (regression)– Leverage (regression)– Interest coverage ratio (regression)– Damodaran credit rating model– Ordered Logit Model


Comparison of results (continued)

Regression (X variable) R Square

Asset size (Log of Assets) 42.2%

Debt/Assets 19.5%

Interest coverage 0.1%

Company Name RatingRegression: Log Assets

Regression: Debt/Assets

Regression: Interest

CoverageOrdered

Logit Damodaran

The TJX Companies, Inc. A BBB- BBB- BB A AAA

eBay Inc. A BBB+ BBB- BB A AAA

AutoZone, Inc. BBB BB+ BB- BB BBB AAA

Roper Industries Inc. BBB BB+ BB+ BB BBB AAA

R.R. Donnelley & Sons Company BB BB+ BB BB B+ B+

Teleflex Incorporated BB BB BB+ BB B+ BB+

Nortek Inc. B BB- BB- BB B CCC

Hercules Offshore, Inc. B BB- BB BB B+ D

Milagro Oil & Gas Inc. CCC B BB- BB CCC D

Stanadyne Corporation CCC+ B BB BB B CC








7


Credit ratingAdjusting for seniority and collateral

• It is extremely important to understand that the developed synthetic credit rating is for the company, not for a specific debt

• One should adjust estimated rating based on considerations of collateral and seniority– No adjustment for senior unsecured debt as a company’s corporate

rating is most closely aligned with senior unsecured debt– Secured debt: rating may be adjusted upward– Subordinated or mezz debt, preferred stock: rating may be adjusted

downward– “Investment vs. non-investment grade” profile dictates magnitude of

adjustment


Credit ratingAdjusting for seniority and collateral (continued)

Debt type Metrics Threshold*Corporate Rating = Investment Grade Threshold*

Corporate Rating = Non-Investment Grade

Expected recovery on subject debt

>= 80% Same as corporate >= 80% Same as corporate

Priority debt/Total Assets

< 20% Same as corporate >= 15% Up to 1 notches below

Subject debt/Total assets

>= 30%*** Up to 1 notches below

>= 30%*** Up to 2 notches below

Priority debt/Total Assets

>= 20% Up to 1 notches below

>= 30% Up to 2 notches below

Preferred stock None 2 notches below At least 3 notches below

Senior PIK debt None 1 notch below 2 notches below

Subordinated PIK debt None 2 notches below At least 3 notches below

* Factors that increase or decrease the threshold are (1) atypical asset mix and (2) the relative size of the subordinated debt debt in relation to the assets assumed to remain after satisfying the more senior layers.** The lowest-ranking issues will never be rated lower than one notch under the investment-grade corporate credit rating, or two notches in the case of noninvestmentgrade corporate credit ratings.*** Based on S&P example. Not a specific guideline.

Source: Standard & Poor's Corporate Ratings Criteria, 2006

Subordinated debt** (Unsecured, subordinated, holdco)








7


Credit spreads and yieldsComponents of risk

• In a business enterprise analysis, the cost of equity using CAPM can be broken down into the following factors– risk-free rate– industry factors (beta)– market factors (ERP)– size (small stock premium)– company-specific factors (achievability of PFI and other unique risks)

• In the valuation of debt and other debt-like instruments, the discount rate or yield is typically composed of the following factors– risk-free rate– spread (or risk premium)

• Industry factors• Credit risk (typically reflected in the credit rating)• Maturity (longer term is deemed to be more risky, all else equal)• Timing of cash flows (e.g., bullet maturity has more risk than amortizing debt)


Credit spreads and yieldsSpreads

• Companies often rely on the following measures of credit spread– Option-adjusted spread ("OAS")– Credit default swap ("CDS") spreads

• Sources of data– Merrill Lynch Indices (High Yield, Corporates, rating- or industry-

specific)• Reuters• Bloomberg

– Comparable debt issuances• Capital IQ


Credit spreads and yieldsOAS vs. CDS spread

• OAS– Spread that equates the present value of all future cash flows of a debt

instrument with its market price– Adjusted for embedded options, such as conversion options, calls, or put

options– Allows for better comparison of yields across different types of debt

instruments• CDS spread

– Credit default swap is a credit derivative that provides protection to the buyer from a default by a particular company or entity (or reference entity)

– The protection buyer makes periodic payments to the protection seller for the right to sell a bond issued by the reference entity to the protection seller for its face value upon a credit event

– CDS spread is the annual rate paid by the buyer to the protection seller


Credit spreads and yieldsOAS vs. CDS spreads

OAS• OAS are available for all entities

that have issued bonds that are trading in the market

• OAS are available for a wide range of maturities

• OAS are not affected by counterparty risk (compared to CDS spreads)

CDS spread• CDS spreads are available for a

more limited universe of reference entities

• CDS spreads are available in maturities of 1, 2, 3, 5, 7 and 10 years only, but are most liquid for a 5-year maturity

• CDS spread includes the risk of both counterparties’ non-performance


Credit spreads and yieldsScreening for comparable OAS

• We recommend relying on OAS when estimating yields • Screening for comparable OAS is similar to finding comparable debt• Make sure proper adjustments were made from the corporate rating to

debt-specific rating based on the following:– Seniority (senior vs. subordinated)– Collateral (secured vs. unsecured)

• Select appropriate OAS based on – Credit rating (adjusted for seniority and collateral)– Maturity / duration (OAS curve is typically upward sloping, but not

lately)– Industry of issuer (only if credit rating was developed based on

industry; use consistent universe)


Credit spreads and yieldsEstimating credit spreads

Method 1: Absolute approach• Estimate spread as of the Valuation Date independently from the

spread as of issuance• Used when the issuance date is stale (more than 2 years has

passed) or when the Company’s financial position / credit profile has changed significantly since the issuance date

Steps:• Estimate a synthetic credit rating as of the Valuation Date• Select an appropriate OAS as of the Valuation Date based on the

estimated credit rating


Credit spreads and yieldsEstimating credit spreads (continued)

Method 2: Relative approach• Observe change in spread since issuance• Used when the issuance date is relatively recent and there were

no changes in company's risk profile

Steps:• Observe an OAS as of the issuance date (validate the synthetic

credit rating or see where OAS falls relative to ratings)• Observe change in spreads between the issuance date and the

Valuation Date• Estimate the OAS as of the Valuation Date


Selecting OASAll data

Universe BB+ BB BB-BB

Overall B+ B B-B

Overall CCC+ CCC CCC-CCC

Overall CC CNumber of data points 2,147 204 274 322 800 248 330 304 882 263 134 34 430 26 8

Low -4 45 104 35 35 159 108 79 79 -4 44 406 44 433 1,77925th Percentile 291 220 235 270 245 297 321 375 327 470 562 792 492 1,095 8,99975th Percentile 547 337 338 391 357 423 492 648 531 718 968 1,530 855 2,038 18,089High 53,790 691 787 1,961 1,961 984 1,338 1,952 1,952 2,744 4,195 5,002 5,002 5,312 53,790

Average 545 287 298 350 316 377 425 536 449 626 914 1,402 779 1,780 17,596Median 383 269 276 317 290 347 388 485 404 557 735 1,243 619 1,647 13,775


Selecting OASFiltered data

Universe BB+ BB BB-BB

Overall B+ B B-B

Overall CCC+ CCC CCC-CCC

Overall CC CNumber of data points 403 38 66 55 154 31 62 45 135 48 38 9 93 10 1

Low 0 0 0 0 138 0 258 0 169 0 179 478 133 788 38,13125th Percentile 329 241 277 311 282 367 386 508 418 560 705 625 602 1,353 38,13175th Percentile 640 377 376 454 394 527 561 686 611 799 932 2,202 937 1,835 38,131High 38,131 553 568 653 653 1,101 1,461 1,408 1,461 1,965 4,898 5,157 5,157 2,143 38,131

Average 669 303 324 385 351 474 502 591 536 712 1,013 1,931 968 1,516 38,131Median 458 311 320 377 336 473 473 610 500 621 820 1,027 745 1,510 38,131

Filtered (OAS)

Filter Detail

Filter Enabled

Filter Count Removed

Seniority Senior Yes 1,490 -657Exclude finance n/a Yes 1,402 -88Exclude utilities n/a Yes 1,367 -35Industry n/a No 1,367 0Ticker CLH No 1,367 0Maturity (years) 2.50 Yes 403 -964Maturity bound (+/- years) 2.50 Yes 403 0


ContactInformation

David DufendachPartnerValuation [email protected]

Oksana WesterbekeManaging DirectorValuation [email protected]

John FerroManaging PartnerValuation ServicesNew [email protected]


Disclaimer

This Grant Thornton LLP presentation is not a comprehensive analysis of the subject matters covered and may include proposed guidance that is subject to change before it is issued in final form. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this presentation. The views and interpretations expressed in the presentation are those of the presenters and the presentation is not intended to provide accounting or other advice or guidance with respect to the matters covered.

For additional information on matters covered in this presentation, contact your Grant Thornton LLP adviser.

valuation of debt and debt like securities

Economy & Finance

valuation of debt

cost of debt

callable debt

convertible debt

debt instruments

outstanding debt

entitys debt

payoff value of debt