Question 1
With the use of Merton Model, the probability of Default (PD) of each firm is summarized as follow:
Company Name | ASX Code | Probability of Default | Adelaide Brighton Limited | ABC | 0% | Buderim Ginger Limited | BUG | 26.079% | FFI Holdings Limited | FFI | 0.056% | McPherson’s Limited | MCP | 0.003% | Reece Australia Limited | REH | 0% | Vietnam Industrial Investments Limited | VII | 2.472% |
Question 2
Using 15 Sep 2008 as a cut-off point, the pre and post results with respect to the Global Financial Crisis (GFC) analysis of PDs for the above 6 firms are summarized as follow: | | Probability of Defaults | Company Name | ASX Code | 7 years | Pre GFC | Post GFC | Adelaide Brighton Limited | ABC |
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This also subsequently led to a higher market value of equity, hence reducing the PD.
d) McPherson’s Limited (ASX Code: MCP)
The PDs for MCP has increased slightly from 0.012% before GFC to 0.056% after GFC. Such insignificant movement in PD was mainly caused by the depreciation of asset value and rise in asset volatility. The impact of unfavorable changes in asset value and asset volatility were then offset by the debt reduction via capital raisings and the appreciation of MCP’s share prices, which has helped MCG to continue to maintain a low PD.
e) Reece Australia Limited (ASX Code: REH)
Similar to ABC, the PDs for REH remain constant at 0% both before and after GFC. The low PD in REH was mainly due to a high asset value but low liabilities of the firm, which has increased the distance to default. REH has been a leading supplier in plumbing and bathroom products with very low gearing ratios and very insignificant level of long term debts. This is due to REH’s strong cash position which minimal borrowing is required. Despite the slowdown of the economy due to GFC, REH was able to maintain its sales level as a result of the government stimulus package. Hence, maintain the strong cash position. The low debt level and strong cash position has provided strong confidence to the investors, which was evidenced by the share prices appreciation.
This is no surprise due to the major expansion that CC took on in 2001. Lastly, the long term debt to capitalization ratio slowly decreases which is just showing how CC is not being risky with their capital through debt.
Effective February 7, 2013, SeaBright Insurance Company (“Seabright”), a Seattle-based insurance company specializing in workers compensation, entered into run-off. In 2012, Enstar Group Limited (“Enstar”), a run-off specialist, purchased SeaBright. SeaBright continues to manage existing claims but no longer writes new or renewal business, which means that premium activity has slowed down. In 2015, a major change occurred when all of SeaBright’s net liabilities (i.e. loss reserves associated with its prior workers comp business) were shifted to an Enstar affiliate, Clarendon National Insurance Company, through a reinsurance agreement. Circumstances that led the company to run-off: SeaBright was placed into run-off driven by weakened underwriting performance associated with reserve strengthening actions for accident years 2007 through 2009, primarily related to increasing medical cost trends. Additionally, SeaBright was facing marketplace challenges associated with its geographic and coverage lines expansion. Seabright has had to deal with significant pressure from its workers comp book developing adversely year-over-year and having to liquidate investments to satisfy claims and expenses. The reinsurance contract with Clarendon did provide major relief but SeaBright still remains a going concern and without premiums coming in and asset base rapidly shrinking, its solvency status as an insurance company remains questionable. The key now is to track the level of credit risk
A more tell tale sign is the quick ratio, or acid test, which has increased year after year. Debt to total assets has decreased over 5% since 2001, indicating less financing of current and long term debt and more company assets. Their cash debt coverage far surpasses the ideal 20%, indicating a high level of solvency with sufficient funds and assets to satisfy all debtors. Asset turnover has more or less maintained at right around 1.6, signifying a turnover rate of just less than 180 times per year.
Miscellaneous factors could impact on the possibilities of default. If any events as such bankruptcy, mergers and acquisitions or force majeure happen,
The firm’s accounts receivable ratio increased from 68.71 in 2006 to 74.56 in 2010. This means that it is taking Abbott almost six days longer to collect from its customers today than it did five years ago. Furthermore, the firm’s accounts payable days has decreased from 43.72 in 2006 to 38.22 in 2010. This means that Abbott is paying its suppliers 5½ days earlier today than it did in 2006. A change in the inventory ratio from 8.01 in 2006 to 11.03 in 2010 indicates that it is taking the firm longer to sell finished goods than it used to. The increase in the accounts receivable and inventory ratios, combined with a decrease in the accounts payable ratio, indicates poor working capital management and helps to explain why the firm has increased its holdings of cash and short-term investments. To correct this, Abbott’s managers should focus on collecting cash from its customers faster and delaying payments to its suppliers. To maximize its cash position, the firm would be best served by paying its suppliers in the same amount of time as it collects payment from its customers.
In terms of financial flexibility, a relatively high interest coverage ratio (ICR) of 36.8 supports the company’s ability to Flexibility take on more debt. Especially by comparing the ratio with its peers, such ratio seems to match with its risk aversion philosophy. Agency Cost of Debt
Several factors may have caused some results to be statistically insignificant in this study, hence a hundred percent conclusion cannot be drawn as fully statistically significant evidence was not ascertained. In addition, although all crisis has similar characteristics, they are actually different in nature. Thus, generalisation may not be possible based on this research in terms of either past or future financial crisis. Especially as this study only considered the 2008 financial crisis in its data analyses. Hence, this study has some limitations in spite of the contribution it makes. The first limitation is that as with other studies, this study suffers from subjectivity. This study defines the variables growth opportunity for example
Due to the consequences of the recent financial crisis, the company has observed a significant decline in the investment activities of its clients all over the world. These consequences brought negative impacts to its financial performance.
Regression analysis seems to be extremely useful in determining financial distress and the bankruptcy of firms. In fact, in a particular study conducted by Bredart in 2014, it was presented that regression analysis was able to show an 84% prediction accuracy rate in determining bankruptcy of 870 firms between the years of 2000 and 2012 (Bredart, 2014). The independent variables used in Bredart study included profitability (net income/total assets), liquidity (current assets/current liabilities), and solvency (equity/total assets) while the dependent variable included financial distress.
A) Using historical recovery rates, what is the implied probability of default? What is the implied IRR?
According to the Equilibrium Theory, at the optimal leverage point the PV of tax expense should be equal to the financial distress costs. Simpson and Williams’ simulation model helped us to find the point, at which point the EBIT/Interest was equal to 2.8. However, financial model does not stand for the real world. The interest coverage of 2.8 is not suitable for Diageo, because there are many defects in the simulation model.
Our choices led to a constant increase in net income over the three years. Short term debt increase by approximately 100% percent but steadily reduced over the next three years. We were happy with the positive growth of the company and the fact that we were able to pay off most of the initial short term funding required by the increase in working capital requirement. Overall the current situation of the company in 2018 is good, although the total value created is less than 20% of that created in phase 1. From this we learned that the value of the firm can be significantly increased more through a reduction in working capital requirement than through increasing the firm’s sales and net income.
Since 2011 Vera Bradley total debt to asset ratio was 33% and it continue decreasing. By 2014 the company reach 0%, which mean the company at this point had no debt. In addition, the debt to equity ratio was very high in 2011 at 104%, and in 2014 since the company had no debt the ratio decrease until it reach 0%. Moreover, the coverage ratio confirms the same fact with a sharp rising ratio, this show how Vera Bradley is in appropriate financially strong position.
The long-term liquidity risk ratio such as LT debt/Equity, D/E, and Total Liabilities to Total Assets all show a decline from year 2005 due to the repayment of debts. The interest coverage ratio also shows a healthy number of 29.45 in comparison to the industrial average of 15.04 indicating a high ability to pay out its interest expense. Such a low relative risk is not surprising due to the nature of its business depending heavily in R&D development and large intangible assets.
Since The Altman’s model widely used among the investors, though it is not an intuitive model, once a firm is predicted having a financial distress next year, it has been treated as it has been financial distress currently (whtaker, 1999).