IB Interview quesion: What is debt trading at..?
Hi guys,
I recently ran into these EV questions when preparing for interviews. I am not sure about the answers and I would really appreciate if someone could explain a bit.
(1) If the current EV of a company is $150mm (equity value=$150mm, book value of debt=$200mm), what is debt currently trading at?
(2) If the current EV of a company is $150mm (secured debt=$75mm, unsecured debt=$125mm), what is equity value? In a chapter 11, how much does each tranche get?
(3) If you have invest $100mm debt in a company that has a 50% chance of being worth nothing and %50 chance of growing to $200mm EV. What is the debt trading at?
Any resources recommended to study for these types of questions?
Thanks in advance for your input.
(1) $150mm/$200mm=75%. This is because the 200mm of EV is split amongst the debt.
(2) EV of 150mm less debt of 200mm means BOOK VALUE of equity is -50mm. But in reality you can't have a negative equity value so the market value of debt should theoretically be 150 and equity should be zero (technically slightly above zero because there's a chance the company recovers, so equity is essentially an option).
In Ch. 11, the 75 is paid off first, so it gets all 75. The 125 junior debt gets the remaining 75 of EV, so it recovers 75/125=60%.
(3) I'd take the expected value of the EV of the company, which is 100mm. If the company is worth 100, then the debt will trade at par.
As for resources, look into Distressed Debt Analysis by Stephen Moyer. Tons of free ebook copies floating around online and on this forum.
Thanks for pointing me in the right direction!
Slight clarification -- you can't take an expected firm value of $100mm (average of zero and $200mm) because the debt doesn't share in the upside above principal amount. There is a 50% chance the debt gets nothing and a 50% chance to get paid in full; the debt should trade at 50% of par (average of zero and $100mm).
Note this would assume the default occurs immediately; in reality there would be an imputed default spread that compensates you over time for the default scenario recovery of 0%.
I thought about that, but that would mean debt should never trade at par because a firm always has some potential of EV going to 0. Taking an expected value of that and par will always yield something below par.
That said, I can see how your answer is correct, but I think theoretically you would average the EV's because ultimately the debt value is derived from that. Although I guess in a purely two state world (where the debt is either worth 0 or worth 100) then you'd be correct.
Understand your logic but it is the credit spread that compensates you for that risk when pricing par bonds. A corporate could issue bonds at the current treasury rate however the bonds would be deeply discounted to compensate for the default risk.
Thanks for the clarification!
(2) is either a trick question or a poorly-written one. Secured debt gets priority on what it's secured against, and the balance is transformed into a unsecured claim. So if the security is worth $50mm, the secured recovers $50mm + $100*$25/($25+$125)
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