Credit Analysis and Distress Predictio
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
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