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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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APPLICATION ISSUES

Many issues arise in the appropriate selection, application, and interpretation of numeric methods, arising from the data as well as the quantitative methods. An appropriate time period must provide sufficient data yet be relevant despite changes in interest rates, business cycle and outlook, competitive dynamics, acquisitions, and of course, force majeur. The data may require normalization for special charges, variations in accounting, off-balance sheet items, and other accounting issues.

Net Debt or Gross Debt?

The relationship between leverage and rating can be much stronger on a gross debt basis than on a net debt basis. Once an issuer has sufficient operating liquidity and strategic reserves, surplus cash is generally better directed toward debt reduction. However, operating liquidity needs do generally rise for weaker credits, where businesses are typically weaker, higher fixed charges must be covered, and income statement gearing creates income volatility. Cash levels are higher due to restricted cash and covenant requirements.

Investment Grade Versus Speculative Grade

Size tends to be a more significant factor for speculative-grade credits showing diminishing returns to scale. Again, debt/EBITDA works better below investment grade, and coverage ratios become much more meaningful. Profitability metrics emerge as more statistically helpful in the analysis of investment-grade credits (notwithstanding their general importance to Technology credits).

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