Finance Question 1.A) Bond Ratings Encompass a Essay

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Finance

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.

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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 €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:

Year

1

2

3

4

5

AAA Bond rate

7%

7%

7%

7%

7%

AAA bond interest

7

7

7

7

7

A- bond rate

8.00%

8.00%

8.00%

8.00%

8.00%

A- bond interest

8

8

8

8

8

Bank loan

8.50%

8.50%

8.50%

8.50%

8.50%

Bank interest

85

85

85

85

85

Difference

-5

-5

-5

-5

-5

Thus, the difference is €5,000,000 per year, without changing the term of the debt. This savings €25 million over the course of the next five years.

c) If the issue's costs are €20 million, that makes a difference in terms of the issue. The total savings from the issue are now going to be €5 million in total, and most of this will be in the future. A present value calculation.....

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