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DEBT ANALYSIS AND
MANAGEMENT
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GROWING INTEREST IN DEBT
Lesser support in the form of term loans
Complete freedom in designing debt instruments
Credit rating agencies
Wholesale Debt Market segment
Massive investments in infrastructure
Volatility of equity market
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RISK IN DEBT
Interest rate risk
Inflation risk
Real interest rate risk
Default risk
Reinvestment risk
Foreign exchange risk
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DEBT RATING
A debt rating essentially reflects the probability of
timely payment of interest and principal by the
borrower.
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FUNCTIONS OF DEBT RATINGS
(OR DEBT RATING FIRMS)
Provide superior information.
Offer low-cost information.
Serve as a basis for a proper risk-return tradeoff.
Impose a healthy discipline on corporate borrowers.
Lend greater credence to financial and other representations.
Facilitate the formulation of public policy guidelines on
institutional investment.
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Debt rating is not:
A recommendation to buy/sell/hold
An overall evaluation of the issuing organization
Indicative of a fiduciary relationship between issuer
and rating agency
An auditing of issuer
A one time evaluation over the life of the security
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RATING METHODOLOGY
Two broad types of analyses are done: (i) industry
and business analysis, and (ii) financial analysis
Industry & business analysis:Growth rates, risk
characteristics,structure, competitive position of issuer,managerial
capability of issuer
Financial Analysis:earning power,risks,asset protection,cash flow
adequacy,financial flexibility, quality of accounting
Subjective judgment often plays an important role.
Industry risk characteristics are likely to set the
upper limit on rating.
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CRISIL DEBENTURE RATING
SYMBOLS
AAA Highest safety
AA High safety
A Adequate safety
BBB Sufficient safety
BB Inadequate safety
B Susceptible to default
C Vulnerable to default
D In default
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DESIGN OF DEBT ISSUES
Maturity period
Fixed versus floating rate
Sinking fund
Options
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INNOVATIONS IN DEBT SECURITIES
Deep discount bonds
Floating rate bonds
Commoditylinked bonds
Bonds with embedded options
Extendable bonds
Structured notes Inverse floaters
Junk bonds
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WAYS IN WHICH SHAREHOLDERS
AND THEIR AGENT-MANAGERS
CAN HURT BONDHOLDERS
Dividend payment
Claim dilution
Asset substitution
Underinvestment
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POSITIVE BOND COVENANTS
A positive (or affirmative) covenant states what the
borrowing firm should do during the term of the loan(bond). Here are some examples of positive covenants:
The firm has to periodically furnish certain reportsand financial statements to the lenders.
The firm agrees to maintain a certain workingcapital.
The firm agrees to set up a sinking fund for
redemption of debt.
The firm has to maintain a certain net worth.
The firm has to mortgage its assets.
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NEGATIVE BOND COVENANTS
A negative covenant prohibits or restricts certain actions by
the borrowing firm, unless the same are approved by theprior permission of the lender. Here are some typical
negative covenants:
The firm cannot raise additional long-term debt.
The firm cannot undertake a diversification project or
acquire another firm or merge with another firm.
The firm may not dispose or lease its major assets.
The firm may not pay dividends in excess of a certain
percentage.
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BOND-REFUNDING DECISION
The bond-refunding decision should be analysed the way any
other capital budgeting decision is analysed. Hence, the
decision rule is:
Refund the bond if the present value of the stream of
net cash savings is greater than the initial cash
outlay.
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INITIAL OUTLAY
Initial outlay =
The terms on the right-hand side of the above expression are defined as
follows:
Cost of calling the old bonds = Face value of the bonds + Call premium
Net proceeds of the new issue = Gross proceedsFloatation costs
(issue expense + discount)
= Tax rate
Cost of calling
the old bonds
Net proceeds of
the new issue
Tax savings on tax-
deductible expenses
Tax savings on tax-
deductible expensesCall premium + Unamortised floatation
costs on the old bond
issue
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ANNUAL NET CASH SAVINGS
Annual net cash savings =
The terms on the right-hand side of the above expression are defined below:
Annual net cash outflowon old bonds Annual net cash outflowon new bonds
Annual net cash outflow
on old bonds
Interest expenseTax saving on interest
expense and amortisation
of floatation cost
Annual net cash outflow
on new bondsInterest expense
Tax saving on interestexpense and amortisation
of issue cost
=
= -
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ILLUSTRATION
To illustrate how the bond-refunding decision should be
analysed, let us consider an example. Acme Chemicals hasRs.100 million, 18 percent bonds outstanding with 10 years
remaining to maturity. As interest rates have fallen, Acme
can refund these bonds with a Rs.100 million issue of 10-
year bonds carrying a coupon rate of 16 percent. The call
premium will be 5 percent. The issue costs on the new
bonds will be Rs.5 million. The unamortised portion of the
issue costs on the old bonds is Rs.3 million and this can bewritten off no sooner the old bonds are called. Acme's
marginal tax rate is 40 percent.
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ILLUSTRATION
The bond-refunding decision may be analysed as follows:
1. I nitial Outlay(a) Cost of calling the old bonds
Face value of the old bonds 100,000,000
+ Call premium + 5,000,000
105,000,000
(b) Net proceeds of the new issue
Gross proceeds 100,000,000
Issue costs 5,000,000
95,000,000
(c) Tax savings on tax-deductible expensesTax rate [Call premium + Unamortised issue costs
on the old bond issue]
0.4[5,000,000 + 3,000,000] 3,200,000
Initial Outlay : 1 (a)1 (b)1 (c) 6,800,000
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ILLUSTRATION
2. Annual Net Cash Savings
(a) Annual net cash outflow on old bondsInterest expense 18,000,000
- Tax savings on interest expense and
amortisation of issue costs
0.4 [18,000,000 + 300,000/10] - 7,320,00010,680,000
(b) Annual net cash outflow on new bonds
Interests expense 16,000,000
- Tax saving on interest expense and amortisation
of issue cost 0.4 [16,000,000 + 5,000,000/10] 6,600,000
9,400,000
Annual net cash savings: 2 (a)2(b) 1,280,000
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ILLUSTRATION
3. Present Value of the Annual Cash Savings
Present value of a 10-year annuity of 1,280,000 using a
discount rate of 9.6 percent after-tax cost of new bonds 8,002,560
(1,280,000 x 6.252)
4. Net Present Value of Refunding the Bonds
(a) Present value of annual cash savings 8,002,560
(b) Net initial outlay 6,800,000
(c) Net present value of refunding the bonds 1,202,560
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VALUATION OF COMPULSORILY CONVERTIBLE
(PARTLY OR FULLY) DEBENTURES
n It aPi n Fi
V0 = + + t= 1 (1+ kd)
t (1+ ks)i j=m (1+ kd)
j
where V0
= value of the convertible debenture at the time of issue
It = interest receivable at the end of period t
n = life of the debenture
a= number of equity shares receivable when part-conversion
or full occurs at the end of period i
Pi = expected price per equity share at the end of period iFj
= instalment of principal repayment at the end of periodj
kd
= investors required rate of return on the debt component
ks
= investors required rate of return on the equity
component
