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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.
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
The three
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.
(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;
of r with respect to p
dr
dp
-(1+i)
p2
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.
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*
Example
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
(quadrant IV)
I = 1000 - 1000 p
(a)
(quadrant III)
(b)
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,
p* = 1 - .3 r* = 1 - .3(.O58) = 0.983.
One
As B increases, the
764
max
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
765
max
r*(B ) r*(B
)
o
max
Figure 4
The Cost of Debt and Debt Capacity
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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)
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
denote the
(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
+
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.
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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.
decreases for
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)
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)
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
= .85 has
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.
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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