Credit Analysis for Corporate Issuers

Disclaimer: Following are the questions provided by CFA Institute to its registered
candidates for practice purpose.

The following information relates to questions 1-9

The following questions are related to Mojofon Holdings:
Mojofon Holdings specializes in the design, manufacturing, and marketing of its own
branded smartphones. An evolving sector, the smartphone market is dominated by few
large firms who together have close to 70% of the global market.

Mojofon’s global market share is consistently around 3%, and it is positioned as a niche
player.

An industry assessment leads to the following observations:

• Competition of the smartphone industry is intense, driven by consistent
technology upgrades and new models with short product life cycles. The large
investment and marketing budgets of dominant players have sustained high
industry concentration.

• New entrants positioned as niche producers of “cult” models like Mojofon

consistently compete for market share.

• Customers are “price-takers,” as smartphones are seen as a necessity. Pricing is

usually set by the top three producers, and small firms have little pricing power.
Surveys show that customers defer new phone purchases unless they have
damaged their phones or there is a leap in technology.

• Core mobile phone technology, such as semiconductor chips and mobile operating
licenses, are concentrated among few key suppliers that command large profit
margins at the expense of phone manufacturers.

• Smartphone shipment has seen low growth in recent years due to market
saturation and high penetration, limited technological advancement, and an
economic slowdown. There are signs the sector is maturing. Industry
concentration is increasing, with the top five firms accounting for 60–70% of
global shipment and industry profit.

1. Based on her smartphone industry assessment, the credit analyst concludes that
Mojofon’s debt service capacity is low because:
A. the threat of substitutes is low.
B. the threat of new entrants and bargaining power of customers are low.
C. the industry rivalry and the bargaining power of suppliers are high.
 Credit Analysis for Corporate Issuers

2. Based on the overall industry assessment, the credit analyst concludes that the
credit conditions for Mojofon will most likely:
A. tighten because the sector is maturing, and industry concentration is increasing.
B. remain unchanged because Mojofon’s market share is constant despite low
industry growth.
C. expand since niche market entrants are consistently seizing market share from
dominant firms.

3. Which of the following will most likely reduce Mojofon’s near-term default risk?
A. A new policy to increase dividends on a steady basis
B. A three-year strategy to pursue acquisitions funded by debt
C. Proactive management of debt maturity by issuing longer-term bonds

4. The credit analyst studies the key financial information of Mojofon and that of its
peers below:

Debt/capital for Mojofon for the current year is closest to:

A. 37.5%.
B. 50.0%.
C. 100.0%.

5. The outstanding bonds of Mojofon contain a covenant that requires its

EBITDA/Interest coverage ratio to be above 3.0. Based on coverage ratio analysis,
Mojofon most likely:
A. has improved its coverage ratio.
B. is in breach of this bond covenant.
C. has lower credit risk than its peers.

6. Based on the financial information, Mojofon’s credit risk is:

A. below that of its peers.
B. similar to that of its peers.
C. above that of its peers.

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 Credit Analysis for Corporate Issuers

7. Mojofon’s capital structure consists of the following:

Mojofon’s bonds all contain a cross-default provision. If the company is to default on

one of its senior unsecured bonds:
A. the secured bonds are likely to have full recovery.
B. the credit loss on senior unsecured bonds will be the same as that on subordinated
bonds.
C. the subordinated bonds will rank below shareholders, who may dictate how
recovery is to be distributed.

8. Half of Mojofon’s senior unsecured bonds are issued by its major operating
subsidiary, which contributes over 90% of the group’s cash flow and assets, and the
remainder of the group’s senior unsecured bonds are issued by the holding company
that relies on dividend upstreamed by its subsidiaries. There is no cross-guarantee
between the holding company and the subsidiary. In an event of default, it is most
likely that:
A. the unsecured bonds issued by the holding company will have a higher recovery
rate.
B. the unsecured bonds issued by the operating subsidiary will have a higher recovery
rate.
C. the recovery rate will be the same for all senior unsecured bonds since they rank
pari passu with each other.

9. Mojofon’s S&P issuer credit rating is B+. Its S&P subordinated bond issue rating is
most likely:
A. BB –.
B. B+.
C. B –.

10. Which bonds most likely rank the highest with respect to priority of claims?
A. Subordinated debt
B. Second lien debt
C. Senior unsecured bond

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 Credit Analysis for Corporate Issuers

Solutions
1. The correct answer is C. Based on the industry assessment:

Industry rivalry and bargaining power of suppliers are all high intensity, implying low
capacity to support debt.

2. The correct answer is A. If the industry is maturing with low growth and the market
becomes further concentrated among a few dominant firms, credit conditions for
smaller smartphone producers will most likely tighten.

3. The correct answer is C. Extending debt maturity proactively will help extend
Mojofon’s debt maturity profile and reduce near-term default risk. B is incorrect, as
debt-funded acquisitions reduce future cash flow certainty and increase credit risk.
A is incorrect since increasing the dividend is a shareholder-friendly action that
increases leverage and credit risk.

4. The correct answer is B. Debt/capital = Debt / (Debt + Equity)

= 100/(100 + 100) = 0.5 or 50% for Mojofon for the current year.

5. The correct answer is B. EBITDA/Interest coverage for Mojofon for the current
year = 20/8 = 2.5. The corresponding ratio for the prior year = 27/5 = 5.4. Therefore,
Mojofon’s coverage ratio has deteriorated, and the company has breached its
coverage ratio covenant (>= 3.0). On the other hand, EBITDA/Interest among its
peers = 55/10 = 5.5, which is much better than that of Mojofon. Based on coverage
ratio analysis, Mojofon has higher, not lower, credit risk than its peers.

6. The correct answer is C. Despite the better profit measure, EBITDA margin, versus
its peers, Mojofon’s cash flow measures, leverage, and coverage ratios are all
considerably worse than its peers. Therefore, it has higher credit risk.

7. The correct answer is A. Senior secured bonds rank the highest in the priority of
claims, and their recovery depends on the value of the asset collateral. Since the
value of asset collateral (60) exceeds the amount of secured bonds outstanding (50),
the secured bonds are likely to have full recovery in an event of default. Senior
unsecured bonds have higher priority over subordinated bonds, which in turn have
higher priority over common equity in insolvency.

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 Credit Analysis for Corporate Issuers

8. The correct answer is B. Senior unsecured bonds issued by the holding company are
said to be structurally subordinated to those issued by the major operating
subsidiary. Debt at the operating subsidiary will be serviced by the cash flow and
assets of the subsidiary first before any funds can be upstreamed to the holding
company to service debt at that level. Since the operating subsidiary accounts for
over 90% of the group’s cash flow and assets but only half of the group’s senior
unsecured debt, the holding company debt can only be serviced after the operating
subsidiary debt is paid in full. The unsecured bonds issued by the subsidiary will most
likely have higher recovery.

9. The correct answer is C. An issuer credit rating is the rating applied to a company’s
senior unsecured debt. The rating agency will usually apply a notching adjustment to
the lower-ranked subordinated debt, whose rating should therefore be lower than
that of the senior unsecured debt.

10. B is correct. Second lien debt has a secured interest in the pledged assets and ranks
higher than the unsecured debt, such as senior unsecured bonds and subordinated
debt.

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