Relevant to ACCA Qualification Paper P4
Recent turmoil in the global credit market has dramatically underlined the importance of debt finance for both individuals and companies. For financial managers, it is just as important to understand how the debt market works, and how to cost debt capital, as it is to understand the operation of the much smaller equity market. This article explores the ways in which lenders decide the rate they will charge against any particular loan.
With equity, capital asset pricing theory teaches us that a firm’s exposure to market risk is the principal determinant of a firm’s equity cost of capital. With debt, market risk is not so important – what is important is whether a borrower will default on a loan. This is called ‘credit risk’.
Default occurs when the value of a borrower’s assets falls below the value of their outstanding debt. Therefore, two variables influence the potential loss to the lender: the chance of default occurring, and the part of the debt that can then be recovered by the sale of the firm’s assets.
At the simplest level, if the probability of a company defaulting is 5%, and only 80% of the debt can be recovered by the lender (that is, 20% will be lost), then at least an extra 1% (20% x 5%) will be charged to cover the potential loss. It’s not as simple as this in practice because the lender loses not only part of the sum advanced but also the accrued interest.
Lenders, whether in the form of banks or subscribers to bond issues, need to discover the potential loss faced on default and therefore the charge needed to cover exposure to credit risk. Lenders rarely undertake assessments of credit risk directly but normally employ the services of credit assessment agencies. For loans to the retail market, there are many credit agencies to which a lender can go. For bigger corporate loans, a lender may undertake the assessment itself or engage a credit rating agency to do it on its behalf. For the largest loans, or where the borrower is considering a bond issue, then the firm concerned will need to obtain a credit risk assessment from a rating agency such as Moody’s, Standard and Poor’s, or Fitch.
TWO APPROACHES TO CREDIT RISK ASSESSMENT
There are two methodologies for undertaking credit risk assessment. The first involves collecting financial and other measures and combining them into a multivariate scoring system. The earliest work on assessing bankruptcy risk was undertaken by William Beaver in 1966, who identified which of the common accounting ratios had the highest predictive value in assessing bankruptcy risk. He showed that one ratio – operating cash flow over total outstanding debt – successfully predicted default within five years with better than 70% accuracy. Edward Altman in the US, and Richard Taffler in the UK, developed more sophisticated multivariate models. Other models, such as that developed by Robert Kaplan and Gabriel Urwitz, focus on explaining the credit ratings given by the agencies. However, a common criticism of all these models is that they have weak theoretical support; they represent a form of brutal empiricism where data is dredged until measures emerge which best explain the phenomenon of interest.
Of course, over the decades, rating agencies have become more sophisticated in the methods they employ. They have also benefited from the theoretical developments that have led to the second of the two approaches to credit risk assessment. This approach is based on what are called ‘structural models’. Structural models rely on an assessment of the underlying riskiness of a firm’s assets or its cash generation, and the likelihood the firm will not be able to pay interest or repay capital on the due date.
ESTIMATING THE CREDIT PREMIUM FOR THE RISK-NEUTRAL LENDER
To take a simple example, supposing a firm has assets with a current value of $1m and outstanding debt of $0.4m. The volatility of those assets (as given by the standard deviation of monthly asset values) is 10%. From this volatility measure, we can calculate the likelihood that within the next 12 months those assets will fall in value to less than $0.4m, thereby triggering default.
A 10% monthly (σm) volatility can be converted to an annual volatility (σa) as follows: