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DECEMBER 1975

I.

Introduction

There is broad consensus that three types of risk confront the potential

bond purchaser:

the risk of interest rate changes (possible principal loss or gain if the bonds

are sold before maturity), and price level risk (loss of purchasing power).

The analysis in this paper is directed toward the first of these risks, the

risk of default.

equal to the present value associated with the investment of their funds in

default-free securities, we examine the process that determines the risk-adjusted

equilibrium interest rate and the factors affecting that rate. We also examine

the implications of the model for the cost of debt and a firm's debt capacity.

In a recent paper J. B. Silvers empirically estimated the certainty equivalent constants the market is applying to the contractual amounts of successive

years.

One is the risk differential that we obtain from the other direction (starting

with a theoretical model and the assumed probabilities). Silvers' other two

factors are the term structure and the risk version considerations.

Silvers

states there exists a set of discount factors reflecting the risk of default,

a premium for risk-bearing and a liquidity risk.

vior specifies the risk differential that an investor would require to compensate him for the first of these, the risk of default, given the probability of

default.

In his classical paper on bond risk premiums, Lawrence Fisher hypothesized

that the average risk premium depends first on the risk that the firm will

V. Rao, and J. McClain are gratefully acknowledged.

Silvers, J. B. "An Alternative to the Yield Spread as a Measure of Risk,"

The Journal of Finance (September 1973), pp. 933-955.

757

The three

variability (as measured by the coefficient of variation of the firm's net income over the past nine years), financial leveraqe (as measured by the firm's

market value of equity to book value of debt ratio), and reliability in meeting

obligations (as measured by the length of time the firm has been operating without forcing creditors to take a loss).

Fisher defines the risk of default as the probability that the firm's

earnings will not be sufficient for the firm to meet the payments on its debts.

The variables noted above are those measurable variables he deems investors consider in estimating the aforementioned probability.

this paper we will present a graphical model of this interest rate setting process.

In the third section we will relate this process to the cost of debt

capital schedule and the debt capacity of a firm under some assumed investor

preferences.

II.

The first objective of this section is to determine the size of the risk

differential on a bond necessary to give an investor an expected present value

equal to the present value he would earn if his funds were invested in a defaultfree security.

For simplicity let us assume that (1) the bond under discussion

is a perpetual bond and (2) the probability of the firm's survival (and consequently meeting its interest obligations) from one period to the next is p, independent of the length of time of survival.

value of the expected interest payments, using the default-free interest rate i:

(1)

(2)

B - (ffj, [ i + (JB_,

2

Fisher, Lawrence. "Determinants of Risk Premiums on Corporate Bonds,"

The Journal of Political Economy (June 1959), pp. 217-237. Since the capital

asset pricing literature uses the term "risk premium" to describe the difference between the expected rate of return and the risk-free rate, we use the

term "risk differential" to describe the difference between the contractual

rate and the risk-free rate.

Both of these assumptions will be relaxed later in the paper.

758

p

Since p, the probability of survival, is less than or equal to one, ^

< 1

and the sum of the infinite series in equation (2) converges so that equation

(2) can be written in closed form:

(3)

If this bond sells at par and pays a contractual rate r, I = rB, equation (3)

becomes

(4)

Thus, equation (4) specifies the contractual rate needed in order for the risky

bond to have the same expected present value as a default-free bond.

Note that

if the probability of survival is 1 (the interest payments are certain), equation (4) reduces to

1+i

r = -

.

1 = i;

Equation (4) is sufficient to illustrate the type of process an expected

monetary value maximizing investor might employ.

of r with respect to p

dr

dp

-(1+i)

p2

contractual interest rate decreases.

We next need to determine the relationship between the amount of interest

that has to be paid and the probability of survival. The firm's operations

(sales and operating leverage) result in earnings before interest and taxes

which are uncertain.

4

Introducing risk-aversion behavior by the investor would intensify the

inverse relationship between the risk of survival and the investor-required

return.

759

Probability

of Survival

Required Contractual

Rate of Return

Figure 1

Investor Required Contractual Rate of Return

760

for all possible levels of interest payments. This is shown in quadrant III

of Figure 2, assuming the firm has no cash resources other than earned income.

Let us now turn to the options available to the firm issuing the debt.

Most important is the fact that, for a given level of outstanding debt, the

probability of survival is inversely related to the contractual interest rate

paid on the debt:

the larger the interest rate, the higher the promised annual

The relationship

between the interest rate (r) and probability of survival (p) is depicted in

quadrant I of Figure 2.

terest rate, say r , on the horizontal axis of either Quadrant I or IV, and

o

trace clockwise around the four quadrants. The implied interest payment for

B

the firm has B par value dollars of debt outstanding and pays interest rate

r , the probability of survival is p . Quadrant II has a 45 line that enables

us to move from Quadrant III to I.

o

velop the interest rate-survival probability set shown in. the first quadrant

of Figure 2 for B of debt.

Finally, Figure 3 shows how to combine the investor's required rate of

return set from Figure 1 (denoted MM) with the interest rate-survival probability feasible set from the first quadrant of Figure 2 (denoted QQ) to ascertain

r*, the minimum interest rate required by the market for B of debt.

The default-risk differential is (r* - i) and from equation (4)

r*

. i = iL _ ! . i

P*

III.

Example

is uniform between $0 and $1000 and the firm wishes to sell $300 worth of bonds

at par.

rate and what is the default risk differential the company must pay?

The solution will be obtained algebraically.

Should MM and QQ cross more than once, the lower or lowest r is, of

course, the correct interest rate since the firm would have to pay higher interest costs at all other r's.

761

1 -

Figure 2

The Interest Rate - Survival Probability Set

762

ir*

Figure 3

Equilibrium Interest Rate Determination

763

I = 300 r

(quadrant IV)

I = 1000 - 1000 p

(a)

(quadrant III)

equation (4):

(b)

I = 300 r and I = 1,000 - 1,000 p

for p in terms of r:

or

(c)

p =

1000 - 300 r

= 1 - .3 r

, .

(00)

Taking the two equations from (a) and (b) above and solving simultaneously for r we find that the two roots are

r = (.058, 2.275)

so that, ignoring the higher root,

The probability of survival is:

p* = 1 - .3 r* = 1 - .3(.O58) = 0.983.

The model presented in the preceding section can be used to determine both

the cost of debt capital schedule and the debt capacity for a given firm.

One

outstanding, B, to find the cost of debt schedule, r*(B).

As B increases, the

Hence for a given investor preference curve, MM, r*(B) will rise as B increases

until MM and QQ are tangent, and the corresponding B, denoted B' , is the

max

764

est rate r*(B

max

debt at intermix

because the firm

max

An equivalent method would be to place the investor preference schedule,

MM, in Quadrant I (see Figure 4).

move counterclockwise through Quadrant II and Quadrant III to determine the market interest payment (I ) that can be paid with probability p .

The point

o

o

(r ,1 ) in Quadrant IV is one point defining a feasible amount of interest for

o o

given investor preference and a given interest rate r . By starting in Quadrant I with different values of r and repeating the process, we obtain the

curve labeled iR which is the set of points (r, I) that the firm could offer

to the market via bond issues and the market would accept. For any given level

of debt the equilibrium promised interest rate is determined by the intersection of the debt curve and iR curve in Quadrant IV. Thus if B

debt is issued

9

it would have to carry a promised rate of r*(B ) . The firm's debt capacity is

o

equal to B

since a larger amount of debt will result in an interest requiremax

ment that is not feasible.

The cost of debt schedule is, of course, a necessary input into any capital structure (mix of debt and equity financing) decision.

ing such a schedule, the above analysis also sheds some light on the extent to

which the firm can substitute debt for. equity financing.

max

mum market value of the firm.

that any earnings over and above the required interest payment I are paid as

equity dividends.

Thus there is an expected dividend stream for any debt level B (including

B

) that will vary in value inversely with the debt level. While further

J

'

max

Referring to Figure 3, as B increases and QQ shifts inward, the relevant

intersection of QQ and MM slides down MM, so that r*(B) increases as B increases.

For a general discussion of corporate debt capacity see G. Donaldson,

Corporate Debt Capacity (Harvard University, 1961).

g

9

Since r*(B ) < r , the firm will issue bonds at r*(B ) rather than r .

o

o

o

o

See footnote 5.

765

max

r*(B ) r*(B

)

o

max

Figure 4

The Cost of Debt and Debt Capacity

766

are in order:

(1)

obligations in periods when income is not sufficient to meet debt

payments, investors would revise upward the probability of survival

over time reflecting this "cushion" effect.

would correspondnicLX

ingly be increased.

next section by examining investor preference behavior when the probability of survival increases over time with successful operations

rather than, as previously assumed, remaining constant.

(2)

have discussed the virtually "all debt-financed firm."

Income limi-

tations and investor preferences will limit the amount of debt a firm

can issue but an equity residual may still remain and carry some market value as long as some probability of a dividend on stock remains.

(3)

While the above analysis assumes investor preferences are solely the

result of expected monetary value considerations, the methodology and

qualitative conclusions do not rely on that assumption.

Risk prefer-

ences can be incorporated into the investor's decision process and the

resultant MM curve would shift to the right.

would depend on the extent to which the investor is risk adverse and

on diversification possibilities (portfolio considerations) implicit

in the firm's income stream.

V. Relaxing the Survival Assumptions

In this section we shall change the assumptions of the model in two ways:

first we shall relax the assumption that the bond has infinite maturity by allowing a principal repayment with a probability measure attached; second, after

ascertaining the equilibrium interest rate assuming finite maturity, we shall

allow for the revision of probabilities of survival, conditional upon past survival and examine how this modification affects the equilibrium interest rate.

These two extensions of the previous model affect the market trade-off curve

MM above, making it a more realistic investor indifference locus.

Let p

Figure 4 would be flatter; its corresponding RR curve would fall- below the

existing one in quadrant IV and the consequent maximum level of debt and the

promised interest payment (I) would be less than it would in the absence of

risk aversion and the expected equity dividend greater.

767

denote the

and N denote the length of time to maturity. The market price of the debt selling at par is B. Assuming investors make decisions on the basis of expected

monetary value, they will be indifferent between investing in a riskless security yielding the default-free rate i and this debt if the promised interest

rate on the debt, r, is such that

fc

(5)

B =

P?" 1 P,d+r)B

-* " +

Dividing both sides by B and rewriting equation (5) using known geometric sum

formulas,

H_1

N-l

^1

M_1

P,(l+r)

- 1

or

P. r

p"" 1 - (l+i)11"1

+

[(1+i)" - p " p 2 l (px - 1 - i)

(7)

p?"1- d+i)""1] + P ? ~ V

Note that if we divide the numerator and denominator of equation (7) by (1+i)

we find

and

iLA

liro

N

which is our earlier equation (4). Equation (4), in fact, holds for a bond of

any length of maturity (N) if the probability of survival is constant over time.

If p..=p_=p equation (7) reduces to equation (4) as follows:

768

[(14-J)N - p N ] (p-l-i)

p)

(p-l-i)

- P N ] (p-l-i)

- p N ] (p-l-i)

N+l

.. .,N

- (l+l) p + p

- pN]

or

(4)

p - l - i

~

1 + i

- - p -

Thus, the risk differential is invariant with the life of the bond when investors maximize expected net monetary value and the probability of survival is a

constant over time.

= p

One explanation is that the risk differential does not change as maturity

changes since the change in the expected present value of the principal repayment is exactly offset by the change in the expected present value of the interest payments.

Suppose the maturity date is put off from N to N + M. Then the change

(loss) in the net expected present value of the principal repayment is

PN+MB

- 1]

while the change (gain) in the net expected present value of the interest pay

ment is

1+i

P - (1+i)

rp

p - d+i)

- 1

or

(4)

as we anticipated.

769

and

p_ for i = .05; these values were computed using equation (7) and defining the

difference between the contractual risky rate (r) and the riskless rate (i) as

the risk differential.

a given p

decreases for

of survival over time. As Fisher's empirical analysis suggests, a history of

past survival enhances the probability of future survival and consequent interest and/or principal collection.

While it is undoubtedly dangerous to claim that probabilities of survival

will always increase with length of survival, if earnings are retained in profitable years and invested in risk-decreasing investments, this will change the

prbbability of survival curve for a given amount of debt.

The proportion of

excess earnings retained, as well as the rate of return earned on their reinvestment and the nature of the investment, will determine the rate at which the

probabilities of survival are revised upward.

While numerous formulations of the probability revision process could be

developed, we will use a simple one that reflects the spirit of the procedure.

Let us assume the probability of surviving in period t is

w + t

O

if the firm

interest r on par value, and if investors are using the expected present value

of the future promised payments discounted at the default-free rate i as the

basis of setting the market price, then:

_ _ N " 1 (W-t-t) I SI rB

t

t=il (S+t) 1 W! (1+i)

(W+N) ! SI B(l+r)

N

(Wl) (S+N) ! (1+i)

or

(8)

B = rBA + B(l+r)G

The calculations for all the tables in this section were performed by

David Downes.

We could also interpret the situation as one where we do not know the

probability of survival, make an estimate of the prior probability, and revise

the probability as new information is obtained.

770

l "

.999

.002

.001

.001

.001

.001

.001

.001

.001

10

20

30

00

.003

.001

.055

.001

.001

.055

.003

.002

.055

.055

.055

.004

.009

.020

l = .950

.055

.056

.056

.059

.068

.055

.056

.058

.066

.084

.055

.057

.060

.073

.105

.003

.005

.010

Maturity (N)

Time to

TABLE 1

.05

l = .900

.117

.117

.117

.118

.123

.136

.117

.117

.117

.117

.117

.117

.117

.117

.120

.135

. .175

.119

.129

.155

. NI

A = J^

.

where

(W+t) 1 SI ., ..-t

._

, w , (1+D

and G =

(s+t)

(W+N) ! S! ..-N

, w , d+i) .

(S+N)

equation (9) for i = .05 and selected values of N, W, and S.

(i)

in Table

w+i

2, there are infinite numbers of W and S pairs such that rrr = p..

S+JL

J.

For any given p , the lower the value of W (or S, since S = W/p ) ,

the faster the rate of revision.

in Table

2, the risk differentials for the lower W are lower than for higher

W's.

(ii)

the risk differential.

that the one with the higher initial probability of collection has

higher risk differentials for some N if the probability of survival

revises slowly.

p

= .85 and p

= 4/5 = .8 in Table 2 for N = 10. The p

= .85 has

(iii)

For any given W and S, the risk differential decreases with length

of time to maturity.

survival are held constant over time, the risk differential was invariant to length of time to maturity.

principal being repaid is higher than with the earlier model when

maturity is lengthened since the probability of survival for each

period revises upward over time; also the expected interest payment

is higher for the same reason, so the risk differential falls in this

case.

772

TABLE 2

VALUES OF RISK DIFFERENTIAL FROM EQUATION (9)

WHEN i = .05

Time to

= .90

Pj_ = -85

= .80

= .67

W+l= 9

W+l=4

W+l= 8

W+l=2

W+l=6

S+l=10

S+l=100

S+l=5

S+l=10

l-3

S+l=9

.111

.116

.184

.239

.250

.452

.495

.099

.115

.182

.199

.224

.352

.444

10

.088

.113

.179

.168

.203

.291

.411

20

.077

.111

.177

.146

.187

.252

.393

30

.073

.110

.176

.137

.181

.238

.389

Maturity (N)

VI.

S+l=100

Conclusions

The Fisher paper of 1959 laid a partial foundation for understanding risk

differentials.

specifying the process and variables that determine the risk differential assigned by the market to the debt of a given firm with a given capital structure.

Using the model developed in this paper we are able to determine the

cost of debt capital curve as well as the debt capacity limit for any given

firm.

Though this paper introduces a unique method of analyzing debt, it must

be classified as a first step.

plex than simple expected net present value as a decision criterion and factors

that affect the likelihood and size (in case of partial payment) of debt obligation payments cannot be neatly summarized into well-behaved probability series.

Thus such factors as risk aversion and portfolio effects must be consid-

of the survival process and how it changes over time must be enlarged upon in

order to better ascertain the cost and limit of debt for a firm.

773

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