Question 1.a) Bond ratings encompass a wide range of elements related to the credit risk of the firm. Moody’s notes that bond ratings include elements of default probability, loss severity, “financial strength” and “transition risk” (Cantor & Fons, 1999). The authors note that within the same sector, bonds of the same rating tend to be comparable both with respect to overall credit quality and specific credit quality characteristics. Over different segments of the bond market, this is not necessarily the case. Bond ratings tend to take in factors like the balance sheet strength of the firm, as well as the expected loss in the event of a default. Thus, the type of assets that the firm holds is an important characteristic. The transition risk reflects the likelihood that the firm will experience outright default without transitioning down through the different risk categories. Firms that are almost assuredly going to transition on their way to bankruptcy will have a better score (all other things being equal) than firms where there is the risk that the company will simply default, with little or no warning.
If TerraVerdi wants to tap the credit markets beyond Banco Blanco, it almost assuredly will need to obtain a credit rating. The credit rating sends a signal to potential investors about the quality of TerraVerdi debt, and it helps the market to price that debt. The underwriter of the debt will have a much more difficult time selling a bond that does not have a credit rating, such is the importance of the credit rating as a signal to the market about the credit quality of the underlying company.
In order to obtain a credit rating, it would have to seek one out from a credit rating agency. The characteristics of the ratings differ, and the company may benefit from seeking a rating with more than one company. For corporate bonds, Moody’s places emphasis on default risk, with loss severity being a secondary characteristic of the rating. The underwriter of the debt would present the financial data of the firm to one of the major bond rating agencies in order to obtain the rating, including data about the issue and pro forma statements that highlight what the firm’s finances will look like post-issue.
b) It is now understood that TV will probably receive an A- rating if it plans to issue less than â‚¬1 billion in debt. The following chart shows the interest rates will be for this bond, and how that differs from the bank loans that the company is currently paying. If the company simply replaces the five-year loan with a five-year bond, the difference will be as follows:
AAA Bond rate
AAA bond interest
A- bond rate
A- bond interest
Thus, the difference is â‚¬5,000,000 per year, without changing the term of the debt. This savings â‚¬25 million over the course of the next five years.
c) If the issue’s costs are â‚¬20 million, that makes a difference in terms of the issue. The total savings from the issue are now going to be â‚¬5 million in total, and most of this will be in the future. A present value calculation would need to be conducted to determine if the present value of those cost savings is worthwhile.
These figures show that the cost savings have almost entirely been eroded by the fee, but not entirely. Thus, the conclusion would remain the same that the bond issue will have a favorable financial outcome for the firm. This of course assumes that the cost of closing the loan early is negligible, which it might not be.
Question 2. A) For this project, the first step is to undertake a net present value calculation. The formula for net present value is as follows:
Source: Investopedia (2012)
b) The first step is to determine which cash flows are included in the calculation. For example, no overhead allocation is included, because that it not a cost incremental to the project. The pilot study and research costs are not included, because they are sunk costs. Prime cost depreciation is the total cost less salvage cost, divided by the number of years. So for this project, depreciation expense is $300,000 per year. This expense is not included in the calculation directly because it is not a cash flow. Depreciation expense does, however, reduce the income taxes that the company has to pay, so that tax benefit is included because it is an incremental cash flow.
(C) The weighted average cost of capital for the division will be the discount rate, not the cost of debt, as per MM. Financing costs are not part of the equation as a result, outside of the discount rate. The only focus of an NPV equation should be on operating costs. The discount rate accounts for the financing costs (or opportunity cost of capital). The division’s cost of capital (13.3%) is not as appropriate as the cost of capital that is adjusted for the project’s risk. The reason is that the project’s risk is more important than the division’s risk. In this case, they are fairly similar so the distinction is less important, but it could be very important if the distinction was more significant. It is also worth considering that the nominal rate should be used rather than the real rate. The inflation is already factored into the NPV calculation — (1+r)^t. Thus, the figure of 12.27% will be the discount used for this project, since it most closely reflects the risk of a project of this type and this length.
a) The revenue calculation is as follows:
Net Cash Flow
Given these inputs, the NPV calculation is as follows:
Based on this calculation, the project would be accepted. The project has a positive net present value of $1.093 million. Thus, we can see that the project has an unequivocal NPV. If we used one of the other discount rates, the project would still be accepted, because the highest discount rate possibility was 13.3%, which would have given us an NPV of $1.05 million, barely any difference.
The only way that this project has a negative NPV is if all manner of inappropriate expenses, like depreciation or overhead allocations are included. This is why it is important that the NPV calculation only include incremental cash flows, not sunk costs, non-incremental flows like overhead allocations and certainly not non-flows like depreciation. The investment allowance is nice to have, but does not make this project profitable, because the amount is too low. The key here is that the project generates at least $3.3 million in revenues for a $1 million initial investment. The 20% gross margin is not that great, but it is enough that the project has positive cash flows.
Cantor, R. & Fons, J. (1999). Rating methodology: The evolving meaning of Moody’s bond ratings. Moody’s. Retrieved April 27, 2012 from http://www.moodys.com/sites/products/AboutMoodysRatingsAttachments/2000400000300541.pdf?frameOfRef=corporate
Investopedia. (2012). Net present value. Investopedia. Retrieved April 27, 2012 from http://www.investopedia.com/terms/n/npv.asp#axzz1tFv4YkMI
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