MID-TERM EXAM Case Study Solution
Question 2:
A.Fixed Income Valuation:
Fixed income valuation is used by the credit rating agencies and the financial companies to analyze the financial statement of the companies regarding the risk possessed by the company or whether the lending should be done to the company or not. Fixed income valuation involves the analysis of credit risk, interest rate risk and fixed income securities possessed by the company. Fixed income valuation helps the investors and lending agencies to identify the risk of the company by analyzing the capital structure of the company. if the company possess high debt in comparison with equity and other financing sources then the companies are given low credit rating which increases the cost of capital of the company because companies with low credit rating used to acquire loan at high interest rate because of high debt involved in the capital structure of the company.
B.Fixed Income Securities:
Fixed income securities are the type of securities which provides fixed return to the investor on their investment. The most common fixed income securities used by the companies are mentioned below.
- Corporate Bonds.
- Preferred stock.
Corporate Bonds:
Corporate bonds are the bonds which are issued by the company in order to raise their capital. The company which is the issuer of the bond provides an interest rate to the investor or the borrower of bond, who provides investment to the company against the bond. In this corporate bond agreement fixed interest rate is defined by the company that will be provided to the borrower of the bond annually, semiannually or any specified period as per the agreement. In this type of borrowing by the company all the risk is taken by the company i.e. if the company defaults or liquidated then the company have to return the borrowing money to the investors of the bond i.e. company is assuming high risk by raising capital through fixed income securities.
Bond Yield Spread:
Bond yield spread is the difference between the interest rate of two different instruments of similar maturity. The yield spread is calculated by calculating the difference between the company’s bond and the treasury bonds. This yield spread provides indication to the investors or lenders that how much risk is possessed by the company. Higher the yield spread higher the difference between company’s bong and treasury bonds and higher the risk possessed by the companies. Large companies used to have low yield spreads which indicate less risk whereas small companies possessed high yield spreads which indicates high risk.
Quality factors of bond ratings:
The quality factors which are analyzed by the lenders and investors of the companies in analyzing the bond are mentioned below.
- Earning statement or financial statement of the company provides the investor with the true financials of the company based on which the investor or lender of the company take the decision whether to invest or lend in the company or not. High and consistent earning companies will be considered less risky whereas the high and inconsistent or low and inconsistent companies are considered more risky which acquired loan on high interest rate due to the nature of their high risk.
- The regulatory environment prevailing in the country also helps the lender or investor to define a risk associated with the company. If the regulatory environment is strict and regulates the companies strictly then the regulatory environment is considered less risky which will also decrease the risk associated with the company in the case of default.
- The international exposure by the company also enables the lenders and the investors to gauge the risk of the company by identifying that in which international market the company has issued their bonds and what risks are associated with that particular international market. Therefore, analyzing the international exposure to which the company is exposed helps to gauge the risk of the company.
Preferred Stock:
Preferred stock are the type of equity stock in which the returns are provided to the investor of preferred stock. Unlike common equity a percentage of return is fixed in the preferred stock which will be provided to the shareholder of the preferred stock over the life of the stock. Whereas, in the common stock return is not defined and the holder of the stock shares in the profit and loss of the company. Moreover, the preferred stocks are given more priority than the common stock i.e. if the company pay dividend then the company should pay first to the preferred stock holder then to the common stockholder which defined that preferred stocks are less risky than the common stocks. In preferred stock the common dividends are set by the board of directors which are fixed over the life of the bond and are provided to the holder of the preferred stock.
Bond Rating Agencies:
Bond rating agencies such as Moody’s and Standard and poor are used to provide the ratings to the companies that issued bonds. The bonds of these companies are evaluated by these rating agencies on a periodical basis by analyzing the capital structure of the company as well as financial ratios of the company. The financial ratios analyzed by the rating agencies are mentioned below.
- Coverage ratios such as debt to total capital or debt to total assets are used to analyze the debt obligation possessed by the company and the ability of the company to pay its debt and other obligation. These ratios also provide the rating agencies that how much debt is obtained by the company against their assets and plays a vital role in identifying the correct rating for the company.
- The profitability ration which involves return on capital employed, return on equity, net profit margins etc. These ratio help the rating agencies to identify the profitability of the company through which the company will be able to service its debt obligation. These ratios plays an important role in providing rating to a particular company.
- Liquidity ratios of the company helps the rating agencies to identify that whether the company is able to service its obligation arising in the near future. Liquidity ratios involve working capital ratios and current ratios.
- Time interest earned ratio is calculated by dividing earnings before interest and taxes by interest expense which indicates that how much time the interest expense is paid from EBIT. Hence, this ratio also plays and important role in providing rating to the company............
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