CFA 56: Fundamentals of Credit Analysis

The risk that a bond's creditworthiness declines is best described by: credit migration risk. market liquidity risk. spread widening risk. Answer- A is correct. Credit migration risk or downgrade risk refers to the risk that a bond issuer's creditworthiness may deteriorate or migrate lower. The result is that investors view the risk of default to be higher, causing the spread on the issuer's bonds to widen. Stedsmart Ltd and Fignermo Ltd are alike with respect to financial and operating characteristics, except that Stedsmart Ltd has less publicly traded debt outstanding than Fignermo Ltd. Therefore, Stedsmart Ltd is most likely to have: no market liquidity risk. lower market liquidity risk. higher market liquidity risk. Answer- C is correct. Market liquidity risk refers to the risk that the price at which investors transact may be different from the price indicated in the market. Market liquidity risk is increased by (1) less debt outstanding and/or (2) a lower issue credit rating. Because Stedsmart Ltd is comparable to Fignermo Ltd except for less publicly traded debt outstanding, it should have higher market liquidity risk. In the event of default, debentures' claims will most likely rank: above that of secured debt holders. below that of secured debt holders. the same as that of secured debt holders. Answer- B is correct. Secured debt holders have a direct claim on certain assets and their associated cash flows whereas unsecured debt holders only have a general claim on the issuer's assets and cash flow. In the event of default, the recovery rate of which of the following bonds would most likely be the highest? First mortgage debt Senior unsecured debt Junior subordinate debt Answer- A is correct. First mortgage debt is the highest ranked debt in terms of priority of claims and is considered secured debt. First mortgage debt will also have the expected highest recovery rate. First mortgage debt refers to the pledge of specific property. Neither senior unsecured nor junior subordinate debt has any claims on specific assets. During bankruptcy proceedings of a firm, the priority of claims was not strictly adhered to. Which of the following is the least likely explanation for this outcome? Senior creditors compromised. The value of secured assets was less than the amount of the claims. The judge's order resulted in actual claims not adhering to strict priority of claims. Answer- B is correct. Whether or not secured assets are sufficient for the claims, this would not influence priority of claims. The difference between pledge assets and the claim becomes senior unsecured debt and still adheres to the guidelines of priority of claims. Although rating agencies assess the creditworthiness of debt issuers and issues, the least likely reason that a fixed income analyst should conduct an independent analysis of credit risk is because rating agencies: may at times mis-rate issues. often lag the market in pricing credit risk. cannot foresee future debt-financed acquisitions. Answer- C is correct. Neither an analyst nor ratings agencies can anticipate unexpected events. Jaco Meyer, a credit analyst, is analyzing the human capital of a company. Such an analysis will most likely give Meyer insight into the: quality of the company's management. strength of the company's balance sheet. power of the company's customers. Answer- B is correct. An analysis of the human capital of a company is the purpose of assessing the strength of its balance sheets or, stated differently, the value and quality of assets supporting the issuer's indebtedness (i.e., collateral). If goodwill makes up a large percentage of a company's total assets, this most likely indicates that: the company has low free cash flow before dividends. there is a low likelihood that the market price of the company's common stock is below book value. a large percentage of the company's assets are of low quality. Answer- C is correct. Goodwill is viewed as a lower quality asset compared with tangible assets that can be sold and more easily converted into cash. In order to analyze the collateral of a company a credit analyst should assess the: cash flows of the company. soundness of management's strategy. value of the company's assets in relation to the level of debt. Answer- C is correct. The value of assets in relation to the level of debt is important to assess the collateral of the company; that is, the quality and value of the assets that support the debt levels of the company. In order to determine the capacity of a company, it would be most appropriate to analyze the: company's strategy. growth prospects of the industry. aggressiveness of the company's accounting policies. Answer- B is correct. The growth prospects of the industry provide the analyst insight regarding the capacity of the company. A credit analyst is evaluating the credit worthiness of three companies: a construction company, a travel and tourism company, and a beverage company. Both the construction and travel and tourism companies are cyclical, whereas the beverage company is non-cyclical. The construction company has the highest debt level of the three companies. The highest credit risk is most likely exhibited by the: construction company. beverage company. travel and tourism company. Answer- A is correct. The construction company is both highly leveraged which increases credit risk and in a highly cyclical industry which results in more volatile earnings. The beverage company is in a non-cyclical industry with less volatile earnings. Based on the information provided in Exhibit 1, the EBITDA interest coverage ratio of Adidas AG is closest to: 7.91x. 10.12x. 12.99x. Exhibit 1. Adidas AG Excerpt from Consolidated Income Statement Year Ending 31 December 2010 (€ in millions) Gross profit 5,730 Royalty and commission income 100 Other operating income 110 Other operating expenses 5,046 Operating profit 894 Interest income 25 Interest expense 113 Income before taxes 806 Income taxes 238 Net income 568 Additional information: Depreciation and amortization: €249 million Answer- B is correct. The interest expense is €113 million and EBITDA = Operating profit + Depreciation and amortization = €894 + 249 million = €1,143 million. EBITDA interest coverage = EBITDA/Interest expense = 1,143/113 = 10.12 times. The following information is from the annual report of Adidas AG for December 2010: Depreciation and amortization: €249 million Total assets: €10,618 million Total debt: €1,613 million Shareholders' equity: €4,616 million The debt/capital ratio of Adidas AG is closest to: 15.19%. 25.90%. 34.94%. Answer- B is correct. Total debt is €1,613 million with Total capital = Total debt + Shareholders' equity = €1,613 + 4,616 = €6,229 million. The Debt/Capital ratio = 1,613/6,229 = 25.90%. Funds from operations (FFO) of Pay Handle Ltd increased in 2011. In 2011 the total debt of the company remained unchanged, while additional common shares were issued. Pay Handle Ltd's ability to service its debt in 2011, as compared to 2010, most likely: improved. worsened. remained the same. Answer- A is correct. If the debt of the company remained unchanged but FFO increased, more cash is available to service debt compared to the previous year. Additionally, the debt/capital ratio has improved. It would imply that the ability of Pay Handle Ltd to service their debt has improved. Based on the information in Exhibit 2, Grupa Zywiec SA's credit risk is most likely: lower than the industry. higher than the industry. the same as the industry. Exhibit 2. European Food, Beverage, and Tobacco Industry and Grupa Zywiec SA Selected Financial Ratios for 2010 Total debt/Total capital (%) FFO/Total debt (%) Return on capital (%) Total debt/EBITDA (x) EBITDA interest coverage (x) Grupa Zywiec SA 47.1 77.5 19.6 1.2 17.7 Industry Median 42.4 23.6 6.55 2.85 6.45 Answer- A is correct. Based on four of the five credit ratios, Grupa Zywiec SA's credit quality is superior to that of the industry. Based on the information in Exhibit 3, the credit rating of Davide Campari-Milano S.p.A. is most likely: lower than Associated British Foods plc. higher than Associated British Foods plc. the same as Associated British Foods plc. Exhibit 3. European Food, Beverage, and Tobacco Industry; Associated British Foods plc; and Davide Campari-Milano S.p.A Selected Financial Ratios, 2010 Company Total debt/total capital (%) FFO/total debt (%) Return on capital (%) Total debt/EBITDA (x) EBITDA interest coverage (x) Associated British Foods plc 0.2 84.3 0.1 1.0 13.9 Davide Campari-Milano S.p.A. 42.9 22.9 8.2 3.2 3.2 European Food, Beverage, and Tobacco Median 42.4 23.6 6.55 2.85 6.45 Answer- A is correct. Davide Campari-Milano S.p.A. has more financial leverage and less interest coverage than Associated British Foods plc, which implies greater credit risk. Holding all other factors constant, the most likely effect of low demand and heavy new issue supply on bond yield spreads is that yield spreads will: widen. tighten. not be affected. Answer- A is correct. Low demand implies wider yield spreads, while heavy supply will widen spreads even further. A credit analyst is assessing a two-year, 13.5% coupon bond with a 1.77 duration. Because of a recent slump in operating revenue, the bond's yield to maturity has increased from 7.20% to 7.50%. The impact of the change in yield to maturity on the return of the bond is closest to: 0.53%. -0.53%. -0.60%. Answer- B is correct. Return impact ≈ -(ΔSpread × DurationEnd) Higher credit risk implies widening of the spread by 30 basis points and a lower return. Return impact = -(30 basis points × 1.77 years) = -53.1 basis points = -0.531%