2017 March/June Q4

Bond valuation + Credit Rating

经典题目
 2017 March/June Q4
Toltuck Co is a listed company in the building industry which
specialises in the construction of large commercial and residential
developments.

Toltuck Co had been profitable for many years, but has just incurred
major losses on the last two developments which it has completed in
its home country of Arumland.

These developments were an out-of-town retail centre and a major

residential development.
 2017 March/June Q4
Toltuck Co.'s directors have blamed the poor results primarily on the
recent recession in Arumland, although demand for the residential
development also appears to have been adversely affected by it
being located in an area which has suffered serious flooding over the
last two years.

As a result of returns from these two major developments being

much lower than expected, Toltuck Co has had to finance current
work-in-progress by a significantly greater amount of debt finance,
giving it higher gearing than most other construction companies
operating in Arumland.
 2017 March/June Q4
Toltuck Co.'s directors have recently been alarmed by a major credit
agency’s decision to downgrade Toltuck Co.'s credit rating from
AA to BBB.

The directors are very concerned about the impact this will have on
the valuation of Toltuck Co.'s bonds and the future cost of debt.

The following information can be used to assess the consequences

of the change in Toltuck Co.'s credit rating.

Toltuck Co has issued an 8% bond, which has a face or nominal

value of $100 and a premium of 2% on redemption in three years’
time. The coupon on the bond is payable on an annual basis.
 2017 March/June Q4
The government of Arumland has three bonds in issue.

They all have a face or nominal value of $100 and are all
redeemable at par. Taxation can be ignored on government bonds.

They are of the same risk class and the coupon on each is payable
on an annual basis. Details of the bonds are as follows:
 2017 March/June Q4
Bond Redeemable Coupon Current market value $
1 1 year 9% 104
2 2 years 7% 102
3 3 years 6% 98

Credit spreads, published by the credit agency, are as follows

(shown in basis points):
Rating 1 year 2 years 3 years
AA 18 31 45
BBB 54 69 86
 2017 March/June Q4
Toltuck Co.'s shareholder base can be divided broadly into two
groups.

The majority of shareholders are comfortable with investing in a

company where dividends in some years will be high, but there will
be low or no dividends in other years because of the cash demands
facing the business.

However, a minority of shareholders would like Toltuck Co to

achieve at least a minimum dividend each year and are concerned
about the company undertaking investments which they regard as
very speculative.
 2017 March/June Q4
Shareholders from both groups have expressed some concerns to the
board about the impact of the fall in credit rating on their investment.
 2017 March/June Q4
Required:

a) Calculate the valuation and yield to maturity of Toltuck Co.'s

$100 bond under its old and new credit ratings. (10 marks)

b) Discuss the factors which may have affected the credit

rating of Toltuck Co published by the credit agency.
(8 marks)

c) Discuss the impact of the fall in Toltuck Co.'s credit rating on

its ability to raise financial capital and on its shareholders’
return. (7 marks) (25 marks)
 Solution: (a) Bond valuation & Yield
思路：

5th Yield to maturity: Kd by IRR

4th IRR need Value of Bond (price today)

3rd Valuation by company spot rate on yield curve

2nd T-bill spot rate on yield curve + spread

1st 最先计算 T-bill spot rate on yield curve

Solution: (a) Bond valuation & Yield
 Solution: (a) Bond valuation & Yield
Year Govt yield Spread Toltuck Co Spread Toltuck Co
spot spot
curve old rating old rating new rating new rating
% % % % %
1 4·81 0·18 4·99 0·54 5·35
2 5·95 0·31 6·26 0·69 6·64
3 6·83 0·45 7·28 0·86 7·69
 Solution: (a) Bond valuation & Yield
Valuation of bond under old credit rating
Year Payment Discount Discounted
factor cash flow
$ $
1 8 1/1·0499 7·62
2 8 1/1·06262 7·09
3 110 1/1·07283 89·09
Bond valuation 103·80
 Solution: (a) Bond valuation & Yield
Valuation of bond under new credit rating
Year Payment Discount Discounted
factor cash flow
$ $
1 8 1/1·0535 7·59
2 8 1/1·06642 7·03
3 110 1/1·07693 88·08
Bond valuation 102·70
 Solution: (a) Bond valuation & Yield
Yield to maturity under old credit rating
Year Payment Discount Discounted Discount Discounted
factor cash flow factor cash flow
$ 8% $ 7% $
0 (103·80) 1·000 (103·80) 1·000 (103·80)
1–3 8·00 2·577 20·62 2·624 20·99
3 102·00 0·794 80·99 0·816 83·23
(2·19) 0·42

Using IRR approach, yield to maturity

= 7 + ((0·42/(2·19 + 0·42)) x (8 – 7)) = 7·16%
 Solution: (a) Bond valuation & Yield
Yield to maturity under new credit rating
Year Payment Discount Discounted Discount Discounted
factor cash flow factor cash flow
$ 8% $ 7% $
0 (102·70) 1·000 (102·70) 1·000 (102·70)
1–3 8·00 2·577 20·62 2·624 20·99
3 102·00 0·794 80·99 0·816 83·23
(1·09) 1·52
Using IRR approach, yield to maturity
=7+((1.52/(1.09+1.52))×(8-7))=7.58%
 Solution: (a) Bond valuation & Yield
Market value of $100 bond has fallen by $1·10 and the yield to
maturity has risen by 0·42%.
 Solution: (b) Considerations for credit rating
思路：

信用评级主要决定因素：probability of default and the recovery

rate.
 Solution: (b) Considerations for credit rating
衡量指标及范围广泛：industry risk, earnings protection,
financial flexibility and evaluation of the company’s
management.

Ø 所处国家的经济状况

Ø 所处行业的基本状况及自身竞争地位

Ø 财务分析：盈利能力、投资回报率、杠杆水平及偿债能力、
短期流动性

Ø 融资能力和渠道

Ø 管理团队能力
 Solution: (b) Considerations for credit rating
1. Country

Toltuck Co.'s debt would not normally be rated higher than the
credit ratings of its country of origin, Arumland. Therefore the
credit rating of Arumland should normally be at least AA. The
rating will also have depended on Toltuck Co.'s standing relative to
other companies in Arumland. The credit agency may have
reckoned that Toltuck Co.'s recent poor results have weakened its
position.
 Solution: (b) Considerations for credit rating
2. Industry

The credit agency will have taken account of the impact of the
recession on property construction companies generally in
Arumland. Toltuck Co.'s position within the industry compared with
competitors will also have been assessed. If similar recent
developments by competitors have been more successful, this is
likely to have had an adverse impact on Toltuck Co.'s rating.
 Solution: (b) Considerations for credit rating
3. Management

The credit agency will have made an overall assessment of

management and succession planning at Toltuck Co. It will have
looked at business and financing strategies and planning and
controls. It will also have assessed how successful the management
has been in terms of delivering financial results. The credit agency
may have believed the poor returns on recent developments show
shortcomings in management decision-making processes and it may
have rated the current management team poorly.
 Solution: (b) Considerations for credit rating
4. Financial

The credit agency will have analysed financial results, using

measures such as return on capital employed. The agency will also
have assessed possible sources of future earnings growth. It may
have been skeptical about prospects, certainly for the short term,
given Toltuck Co.'s recent problems.
 Solution: (b) Considerations for credit rating
The credit agency will also have assessed the financial position of
Toltuck Co, looking at its gearing and working capital management,
and considering whether Toltuck Co has enough cash to finance its
needs. The agency will also have looked at Toltuck Co.'s
relationship with its bankers and its debt covenants, to assess how
flexible its sources of finances are if it comes under stress.
 Solution: (b) Considerations for credit rating
It may well have been worried about Toltuck Co.'s gearing being
higher than the industry average and concerned about the high levels
of cash it needs to finance operations.

It will also have assessed returns on developments-in-progress

compared with commitments to repay loans. Greater doubt about
Toltuck Co.'s ability to meet its commitments is likely to have been
a significant factor in the fall in its rating.

The agency will also have needed reassurance about the quality of
the financial information it was using, so it will have looked at the
audit report and accounting policies.
 Solution: (c) Effect from Fall in credit rating
思路：

1. 导致未来融资困难

• Less willing to provide loan

• Come with covenants

2. 增加融资成本，降低盈利性，继而影响股东收益和财富价值

• Cost of debt (coupon) increase

• Cost of equity increase

• Different shareholders preferences

Thank You
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