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holder of its debt. Credit analysis is important to a wide variety of economic agents”
not just bankers and other ¬nancial intermediaries, but also public debt analysts, indus-
trial companies, service companies, and others.
Credit Analysis and Distress Prediction

14-17 Part 3 Business Analysis and Valuation Applications

At the heart of credit analysis lie the same techniques described in Chapters 2 through
10: business strategy analysis, accounting analysis, ¬nancial analysis, and portions of
prospective analysis. The purpose of the analysis is not just to assess the likelihood that
a potential borrower will fail to repay the loan. It is also important to identify the nature
of the key risks involved, and how the loan might be structured to mitigate or control
those risks. A well-structured loan provides the lender with a viable “exit strategy,” even
in the case of default. A key to this structure is properly designed accounting-based
Fundamentally, the issues involved in analysis of public debt are no different from
those involved in evaluating bank loans or other private debt. Institutionally, however,
the contexts are different. Investors in public debt are usually not close to the borrower
and must rely on other agents, including debt raters and other analysts, to assess credit-
worthiness. Debt ratings, which depend heavily on ¬rm size and ¬nancial measures of
performance, have an important in¬‚uence on the market yields that must be offered to
issue debt.
The key task in credit analysis is the assessment of the probability of default. The task
is complex, dif¬cult, and to some extent, subjective. A small number of key ¬nancial ra-
tios can help predict ¬nancial distress with some accuracy. The most important ¬nancial
indicators for this purpose are pro¬tability, volatility of pro¬ts, and leverage. However,
the models cannot replace the in-depth forms of analysis discussed in this book.

1. What are the critical performance dimensions for (a) a retailer and (b) a financial ser-
vices company that should be considered in credit analysis? What ratios would you
suggest looking at for each of these dimensions?
2. Why would a company pay to have its public debt rated by a major rating agency
(such as Moody™s or Standard and Poor™s)? Why might a firm decide not to have its
debt rated?
3. Some have argued that the market for original-issue junk bonds developed in the late
1970s as a result of a failure in the rating process. Proponents of this argument sug-
gest that rating agencies rated companies too harshly at the low end of the rating
scale, denying investment grade status to some deserving companies. What are pro-
ponents of this argument effectively assuming were the incentives of rating agencies?
What economic forces could give rise to this incentive?
4. Many debt agreements require borrowers to obtain the permission of the lender be-
fore undertaking a major acquisition or asset sale. Why would the lender want to in-
clude this type of restriction?
5. Betty Li, the CFO of a company applying for a new loan, argues: “I will never agree
to a debt covenant that restricts my ability to pay dividends to my shareholders, be-
cause it reduces shareholder wealth.” Do you agree with this argument?
570 Credit Analysis and Distress Prediction

Credit Analysis and Distress Prediction

6. Cambridge Construction Company follows the percentage-of-completion method for
reporting long-term contract revenues. The percentage of completion is based on the
cost of materials shipped to the project site as a percentage of total expected material
costs. Cambridge™s major debt agreement includes restrictions on net worth, interest
coverage, and minimum working capital requirements. A leading analyst claims that
“the company is buying its way out of these covenants by spending cash and buying
materials, even when they are not needed.” Explain how this may be possible.
7. Can Cambridge improve its Z score by behaving as the analyst claims in Question 6?
Is this change consistent with economic reality?
8. A banker argues: “I avoid lending to companies with negative cash from operations
because they are too risky.” Is this a sensible lending policy?
9. A leading retailer finds itself in a financial bind. It doesn™t have sufficient cash flow
from operations to finance its growth, and is close to violating the maximum debt-to-
assets ratio allowed by its covenants. The Vice-President for Marketing suggests:
“We can raise cash for our growth by selling the existing stores and leasing them
back. This source of financing is cheap, since it avoids violating either the debt-to-
assets or interest coverage ratios in our covenants.” Do you agree with his analysis?
Why or why not? As the firm™s banker, how would you view this arrangement?

1. The same is true of preferred dividends. However, when preferred stock is cumulative, any
dividends missed must be paid later, when and if the firm returns to profitability.
2. Other relevant coverage ratios are discussed in Chapter 9.
3. Robert Kaplan and G. Urwitz, “Statistical Models of Bond Ratings: A Methodological In-
quiry,” Journal of Business (April 1979): 231“261.
4. See Robert Holthausen and Richard Leftwich, “The Effect of Bond Rating Changes on
Common Stock Prices,” Journal of Financial Economics (September 1986): 57“90; and John
Hand, Robert Holthausen, and Richard Leftwich, “The Effect of Bond Rating Announcements on
Bond and Stock Prices,” Journal of Finance (June 1992): 733“752.
5. See Edward Altman, Corporate Financial Distress, New York: John Wiley, 1983.
6. See Edward Altman, “Financial Ratios, Discriminant Analysis, and the Prediction of Cor-
porate Bankruptcy,” Journal of Finance (September 1968): 589“609; Altman, 1983, op. cit.; Wil-
liam Beaver, “Financial Ratios as Predictors of Distress,” Journal of Accounting Research,
supplement, 1966: 71“111; James Ohlson, “Financial Ratios and the Probabilistic Prediction of
Bankruptcy,” Journal of Accounting Research (Spring 1980): 109“131; and Mark Zmijewski,
“Predicting Corporate Bankruptcy: An Empirical Comparison of the Extant Financial Distress
Models,” working paper, SUNY at Buffalo, 1983.
7. Zmijewski, op. cit.
8. Altman, 1983, op. cit.
Adelphia Communications Corporation

I n mid-April 1996 Sarah Kim, a senior lending of¬cer at a major U.S.
bank, was considering Adelphia Communications Corporation, the seventh largest U.S.
cable provider. Adelphia had applied to the bank for a $690 million ¬nancing arrange-
ment, consisting of a $540 million revolving credit facility and a $150 million term loan
facility. The funds provided by this arrangement would be used to pay down existing
Business Analysis and
bank debt, and to ¬nance Adelphia™s upgrade of its cable system. Valuation Tools
Kim had no prior experience with the cable industry, and was surprised to ¬nd that
Adelphia was highly unpro¬table and already had extraordinarily high leverage. As a re-
sult, her initial thought was to reject Adelphia™s request out of hand. However, she de-
cided that she should ¬rst spend some time understanding the cable business. This would
then provide a better basis for considering Adelphia™s request.

Credit Analysis and Distress Prediction
Created in 1948 as a “community antenna” system for rural areas with weak broadcast
signals, cable television grew steadily through the mid-1970s. However, the night of
September 30, 1975, when Muhammad Ali™s 14-round boxing ¬ght with Joe Frazier in
Manila was transmitted live to cable subscribers, changed the industry forever. There-
after, subscribership growth spread rapidly to urban areas. By the mid-1990s the cable
industry provided services to 63 percent of U.S. households with TVs. Earnings before
interest, taxes, depreciation, and amortization (known as EBITDA or “cash ¬‚ow”) per
subscriber were $169.85 in 1994, and industry EBITDA and revenues were $9.93 billion
and $22.6 billion respectively.
Cable television systems offered subscribers a package of video services including
local network channels; public, government, and educational channels; and premium
news, sports, family entertainment, music, weather, and shopping channels. Subscribers
could also view recent movies, live and taped concerts, sports events, and other program-
ming on a pay-per-event basis. Cable television providers were awarded a franchise to
provide these services by state or local government authorities for a de¬ned period. In
return, they paid the authorities an annual franchise fee of up to 5 percent of gross rev-
Professor Paul Healy prepared this case as the basis for class discussion rather than to illustrate effective or
ineffective handling of an administrative situation. The case has bene¬ted from the help of Lucca Fabri and
comments of Michael Schwartz, Liz Kramer, and Holly Holtz. Copyright © 1997 by the President and Fellows of
Harvard College. Harvard Business School case 9-198-031.

572 Credit Analysis and Distress Prediction

Credit Analysis and Distress Prediction

Once they received a franchise to provide services to a community, cable operators

Adelphia Communications Corporation
made large upfront expenditures for laying cable to subscriber neighborhoods and for
broadcast equipment. These initial system outlays generally acted as a barrier to entry
for competitors.1 Cable laying costs ranged from $10,000 per mile in rural areas to as
much as $300,000 per mile in major cities where cables have to be laid underground. In
addition to the initial capital outlays, cable operators incurred costs for program content
from the major networks (ABC, NBC, CBS, and Fox) as well as pay-TV programmers
such as Disney, Turner Broadcasting, and Time Warner.
Cable operator revenues were typically generated from monthly subscriber fees for
programming, as well as fees for special pay-per-view services and installations. These
fees had been regulated by the Federal Commerce Commission (FCC). The Cable Com-
munications Policy Act of 1984 deregulated basic service rates for systems in commu-
nities meeting the FCC™s de¬nition of effective competition. However, the 1992 Cable
Act contained a new de¬nition of effective competition, and subjected almost all U.S.
cable systems to regulation of basic service rates.
By the mid-1990s, growth in sign-ups of new subscribers had begun to ¬‚atten out and
the industry was facing a number of important changes. These included the increased con-
solidation of many of the small cable providers, signi¬cant new regulations in the telecom-
munications industry, the development of competing forms of multichannel networks, and
the opportunity for cable operators to provide subscribers access to the Internet.

Industry Consolidation
Consolidation of the cable industry began in the late 1980s, as operators sought to gain
bene¬ts from programming discounts and improved capital utilization. Thus began a
race to accumulate market share, primarily through acquisition. In 1993 and 1994 $43
billion of acquisitions took place in the broadcasting industry, many among cable oper-
ators. The average acquisition cost per subscriber in 1994 was $1,869. Many of these ac-
quisitions were ¬nanced with debt, increasing the ¬nancial burdens of the largest
operators. The six leading multiple system operators, or MSOs, which emerged from this
consolidation”TCI, Time Warner, Continental Cablevision, Comcast, Cox Communi-
cations, and Cablevision Systems”had a 63 percent share of the cable market in 1996.
Exhibit 1 reports revenues, EBITDA, capital expenditures, debt obligations, and sub-
scriber base for each of these ¬rms.

New Telecommunications Regulations
The telecommunications Act of 1996 had several implications for the cable industry. It
permitted cable companies to offer local telephone services using their cable infrastruc-

1. Although franchise agreements were generally nonexclusive, only a few communities had more than one cable
company serving the same subscribers. Allentown, Pennsylvania was one such community.
Credit Analysis and Distress Prediction

14-21 Part 2 Business Analysis and Valuation Tools

ture. It was estimated that an investment of $40 to $90 could make a household™s cable
Adelphia Communications Corporation

plug phone-ready. Furthermore, long-distance telephone carriers were eager to supply
their know-how and exchanges to cable operators. This potential growth opportunity
was offset by new rules permitting telephone companies to offer entertainment services
to their own customers. Finally, the new regulations eliminated rate regulation in the ca-
ble industry as of March 31, 1999. The regulations therefore created new opportunities
for cable companies, but raised the prospect of competition from telephone companies.

New Forms of Multichannel Networks
Competition for the cable industry had intensi¬ed with the successful introduction of
several alternative video delivery systems, direct-to-home satellite and wireless cable.
Direct Broadcast Satellite (or DBS) used powerful satellites to transmit up to 175 digital
channels to 18-inch satellite receivers mounted on its subscribers™ homes at a price com-
petitive with traditional cable. DBS systems had higher quality digital broadcasts and a
larger array of channels than traditional cable, but did not include coverage of local net-
works. The major providers of DBS systems were DirecTV (owned by Hughes), Echos-
tar, and Primestar (owned by TCI). DirecTV and Echostar sold subscribers satellite
dishes and receivers for $150 to $400 whereas Primestar rented this equipment to users.
Other companies entering the market included long-distance telephone giant AT&T,
which purchased a 2.5 percent stake in DirecTV for $137.5 million in January 1996.
AT&T planned to market DirecTV to its 90-million customer base, and had the option
to acquire up to 27.5 percent of DirecTV at a discount tied to the number of new cus-
tomers that it signed up. In addition, MCI and Rupert Murdoch™s News Corporation
formed a joint venture to use DBS to provide up to 170 digital channels of entertainment
to all 50 states.
Wireless cable or MMDS (Multichannel Multipoint Distribution Service) systems
used a line-of-sight microwave network to send video signals to subscribers. MMDS sys-
tems avoided the expensive construction costs of DBS and cable systems. Like DBS, they
did not require municipal franchises to operate and were free of several of the more bur-
densome cable regulations. The downside of MMDS systems was their limited analog
capacity (a maximum of 33 channels), “rain fade,” and the fact that the signal could not
be clearly received in “shadow” areas. The early entrants in this market include Bell At-
lantic, NYNEX, and Paci¬c Telesis.
The increased competition, particularly from DBS, had generated different responses
within the cable industry. Time Warner and TCI announced that they would continue
using one-way digital technology. However, Comcast, Cox, and Cablevision began up-
grading their systems to permit two-way transmissions. Two-way data transmission
required cable and electronic equipment capable of delivering a signal from the cus-
tomer back to the cable operator™s headend. This permitted full interactive video services


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