Debt Valuation Research Paper Starter

Debt Valuation

(Research Starters)

Debt valuation can be defined as the appraisal of the amount of debt that has been incurred by a company. Companies incur debt or secure credit for a number of reasons that may include the financing of organizational growth, financing a merger or acquisition or to keep an organization solvent during a financial downturn. Some organizations wish to avoid debt at any cost and use the pay-as-you-go strategy to finance growth and operations. Other organizations see debt (or securing credit) as a way to finance growth and opportunities that might otherwise be beyond reach. This essay discusses the implications of business debt from the opportunity standpoint and explores the ways in which debt has been used to fund an era of recent and unprecedented corporate growth and mergers and acquisitions. The rise in the levels of corporate debt will be discussed in terms of its historical significance and the current challenges that organizations face in securing and managing their debt. No current review of this topic would be complete without discussing the role of private equity firms (PE) and the phenomenon of leveraged buyouts (LBO) and their role in the explosion of corporate debt.

The rise of the issuance of corporate debt from 2003-2007 has been astounding by almost any measure. Low interest rates, rising corporate profits and lots of global credit are cited as helping to fuel an era of rising corporate debt. The early years of the new millennium are somewhat reminiscent of the credit markets that were the norm in the 1990s. In the 1990s, corporate bond issuance or selling of corporate debt was very high. Rapid economic growth was occurring, but the corporate debt load was also bigger than it had ever been. Many felt that even a slight slowing of the economy combined with a rise in interest rates could change manageable debt into debt that would put corporations and individuals under strain. In the 1990s, big debt payments caused companies to cut back on capital expenditures and the potential downturn in the economy was seen as a sure sign that defaults would rise, liquidity would dry up and an overall credit crunch would arise. In the late 1990s, companies were borrowing at rates that had never previously been experienced. Corporate debt was being used for:

  • Corporate stock buy-backs (re-purchases)
  • Financing for acquisitions and mergers
  • Funding of high tech prospects for exponential growth
  • Telecom industry growth.

Rising Corporate Debt

The following examples show the trend toward rising corporate debt in the late 1990s. Computer Associates (a high tech darling) had just $50 million in long term debt in 1995, but by 1999, its debt service was $5 billion. Telecom growth was spurred by de-regulation, new technology and competition and debt was incurred by many companies to make a move in the market. During the first half of 1999 alone, $20 billion in corporate defaults had occurred worldwide with 85% being in the USA.

The following warning was being sounded in late 1999. "The most alarming sign of trouble ahead may be what's happening to corporate balance sheets. Despite the huge gains in the stock market, there is a pronounced tilt in corporate financing toward debt and away from equity. Even at today's prices, companies are buying back far more stock than they are issuing. Over the past 12 months, an eye-popping 3.6% of gross domestic product went into stock buybacks, and even with the IPO boom, nearly $500 billion in equities have been taken off the market since 1997" (Mandel, 1999).

Negative Impacts of Debt

The dotcom bust of early 2000 was a wakeup call to many investors and financial institutions. Stock prices fell 40%. The Federal Reserve lowered interest rates to help stimulate the economy as threats of recession loomed. Stock prices remained stagnant, but corporate profits kept rising. Many saw the rise of private equity (PE) firms as an natural outcome to economic conditions shortly after the tech/telecom bust. Those conditions were: Depressed stock prices, low interest rates and rising corporate profits. With a "dollop" of cash and loads of debt, PE firms began to snap up companies on the cheap. The average buyout in 2002 was 4 times the price of the company's cash flow (aka EBITA). It was not uncommon for PE firms to borrow 70% of the purchase price for these acquisitions. The loans were then put on the acquired company's balance sheet which doubled or even tripled the company's debt load (Tully & Hajim, 2007).

By 2003, the Federal Reserve had slashed interest rates in an effort to get the economy growing after the tech/telecom bust. Corporate profits continued to remain strong, and with the opening of global markets and associated global credit, the era of corporate mergers was ushered in. Lots of cheap and readily available credit and a higher tolerance for risk helped bolster many private equity firms and their LBO deals.

A brief discussion of differing attitudes about the value of debt will follow as well as an overview of corporate credit ratings as they pertain to today's trends in corporate debt. Finally, this essay will outline some of the current trends and outlooks related to tightening credit markets, investor risk tolerance and the potential for market corrections in relation to potential corporate failure.


Risk Assessment of Debt

Corporate credit ratings help investors determine the amount of risk associated with acquiring debt. Credit ratings are independent objective assessments of credit worthiness. Ratings "measure the ability or willingness of an entity (person or company) to keep its financial commitment to repay debt obligations (Heakal, 2003). Three of the most widely respected raters of corporate credit are: Moody's, Standard & Poor's, and Fitch IBCA. Each of these rating agencies provides a rating system that helps to determine the credit risk when acquiring a corporation's debt. Ratings can be assigned to long term or short term debt. For example, Standard and Poor's AAA rating is given to companies with the highest investment grade and very low credit risk. This credit-worthiness indicated a company's high ability and willingness to repay its debt. "Investment grade" is the level of quality that is generally thought to be required for an investor considering overseas investments. It is interesting to note that in the 1990s, investment grade was more of a requisite for incurring debt than it has been in recent years. PE firms have not paid as much attention to the ratings (since 2003) and have basically been much more tolerant of risk as many PE firms have bought and sold lower grade or "junk" investments.

Bond Ratings Moody's Standard & Poor's Grade Risk Aaa AAA Investment Lowest Risk Aa AA Investment Low Risk A A Investment Low Risk Baa BBB Investment Medium Risk Ba, B BB, B Junk High Risk Caa/Ca/C CCC/CC/C Junk Highest Risk C D Junk In Default

The Value of Debt

Many companies are opposed to borrowing funds or leveraging debt to fund operations and growth. Many privately-held companies are debt-free by choice, while many other companies (ex: service companies) don't have the means to support long-term borrowing and are debt-free by necessity. Many business owners and corporate management teams feel a great deal of security in knowing that their organizations are not mired in debt, and may even have a sense that a lack of debt makes their business more attractive in the marketplace. However, in the age of...

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