MCQ Quiz

A corporate group has a holding company and a single major operating subsidiary that generates 90% of consolidated cash flows and assets. Both entities have outstanding senior unsecured bonds, and there are no cross-guarantees. In a group-wide default, which unsecured bonds most likely have the higher recovery rate?

• Holding-company unsecured bonds, because they sit at the top of the corporate structure.
• Operating-subsidiary unsecured bonds, because they are serviced directly from operating assets before upstreaming cash.
• Both have identical recovery, because they share the same senior unsecured label in legal documentation.

Two firms, CycleCo and StableCo, are identical today in size and capital structure and operate in different industries.

Current year data (both firms):
- EBIT margin: 18%
- Debt/EBITDA: 2.0x
- EBIT/Interest expense: 5.0x
- RCF/Net debt: 30%

Qualitative information:
- CycleCo operates in a highly cyclical, economically sensitive capital goods industry with high operating leverage.
- StableCo operates in a non-cyclical, essential consumer staples industry with low operating leverage.

Assume a moderate recession is expected in the next 2 years. Which statement best describes relative <em>forward-looking</em> credit risk?

• CycleCo has higher forward-looking probability of default than StableCo despite identical current ratios.
• Both firms have similar forward-looking probability of default because current ratios are identical.
• CycleCo has lower forward-looking probability of default because operating leverage magnifies profits in recoveries.

RatingCo assigns Issuer X a corporate (issuer) rating of BB, which by convention applies to its senior unsecured debt. Issuer X has the following additional instruments:

- First-lien senior secured term loan
- Subordinated unsecured notes

RatingCo follows a typical methodology where:
- Issuer rating reflects POD on senior unsecured debt.
- Individual issue ratings incorporate LGD via notching around the issuer rating.

Assume a typical capital structure where secured lenders have materially higher expected recovery and subordinated lenders have materially lower recovery than senior unsecured. Which of the following most likely reflects the pattern of issue ratings?

• First-lien secured: BB+; Senior unsecured: BB; Subordinated unsecured: B+ or B.
• First-lien secured: BB; Senior unsecured: BB; Subordinated unsecured: BB.
• First-lien secured: B+; Senior unsecured: BB; Subordinated unsecured: BB+.

Two firms in the same industry have identical EBITDA margins and business risk. Firm A has lower Debt/EBITDA, lower EBITDA/interest coverage, and a much weaker liquidity position than Firm B. From a credit perspective, which statement best characterizes their relative credit risk?

• Firm A is clearly safer because lower leverage always dominates coverage and liquidity considerations.
• Firm B may be safer overall, because stronger coverage and liquidity can offset moderately higher leverage.
• They must have identical credit risk because leverage is the primary driver of default probability in corporate analysis.

You are given the following simplified data for Issuer Q (all in the same currency):

- Net income from continuing operations: 220
- Depreciation & amortization: 40
- Deferred income taxes: 20
- Other non-cash items: 20
- Increase in working capital: 60
- Dividends paid: 80
- Capital expenditure: 120
- Gross debt: 1,000
- Cash and marketable securities: 150

Which of the following leverage metrics best reflects the issuer’s ability to de-lever from internal cash generation, and what is its value?

• FFO / Debt = 30%
• RCF / Net Debt = 26%
• Debt / EBITDA = 4.0x

A defaulted issuer has USD 50 of senior secured bank loans fully collateralized by cash, USD 100 of senior unsecured bonds, USD 20 of subordinated bonds, and USD 60 of equity. An impairment of USD 80 hits non-cash assets. Assuming strict priority of claims and pari passu treatment within each class, which statement is most accurate about recoveries?

• Secured loans recover in full; subordinated bonds are wiped out; unsecured bonds suffer a partial but non-zero loss.
• Unsecured and subordinated bonds suffer identical percentage losses, because they are both unsecured obligations.
• Equity absorbs all losses first; no bondholder suffers any loss unless total impairment exceeds equity.

A credit analyst is deciding whether to use EBIT, EBITDA, funds from operations (FFO), or retained cash flow (RCF) in assessing a corporate borrower’s ability to service debt. Which metric most conservatively reflects the ongoing cash that remains available to reduce debt after maintaining operations and paying dividends?

• EBIT, because it excludes interest and taxes and therefore best measures operating performance.
• EBITDA, because adding back non-cash charges always yields the most conservative view of cash available for debt service.
• RCF, because it starts from operating cash flow and subtracts dividends, reflecting cash truly retained in the business.

Two issuers, M and N, have the following key ratios and are otherwise similar in business risk and size.

Issuer M
- Debt/EBITDA: 3.0x
- EBIT/Interest expense: 7.0x
- EBITDA margin: 25%

Issuer N
- Debt/EBITDA: 1.8x
- EBIT/Interest expense: 2.5x
- EBITDA margin: 12%

Assume similar debt maturity profiles and liquidity. Which statement best reflects their relative credit profiles?

• M has weaker credit quality because its leverage (Debt/EBITDA) is higher than N's, despite stronger coverage.
• N has weaker credit quality because low profitability and weak coverage offset its lower leverage.
• They have similar credit quality because higher leverage at M is exactly offset by its higher coverage.

A credit analyst wants to compare leverage of two issuers with very different cash balances and dividend policies. Which metric most directly captures their ability to reduce net indebtedness from internally generated cash while holding business risk constant?

• Debt/EBITDA, because it links total debt to a broad measure of operating performance before non-cash charges.
• Retained cash flow (RCF)/net debt, because it compares post-dividend operating cash to debt net of cash and marketable securities.
• EBIT/interest expense, because it measures how many times operating profit covers interest payments.

A corporate borrower operates in an industry with high threat of new entrants, strong bargaining power of suppliers, strong bargaining power of buyers, and intense industry rivalry. All else equal, how does this structure affect the industry’s capacity to support financial leverage over the cycle?

• Capacity to support debt is low, because sustained margin pressure and volatility weaken stable cash generation.
• Capacity to support debt is high, because competitive intensity ensures continuous efficiency gains and pricing power.
• Capacity to support debt is neutral, because industry structure affects equity risk only, not debt-servicing ability.

A B-rated issuer, LeverCo, has the following features:

- High but stable EBIT margin: 20%
- Debt/EBITDA: 4.0x
- EBIT/Interest: 2.8x
- RCF/Net debt: 10%
- All existing bonds are senior unsecured and covenant-lite (only basic affirmative covenants).

Management is considering issuing a large, secured term loan to fund a special dividend and share buyback. The new secured term loan would be first-lien on key assets, ranking ahead of existing senior unsecured bonds.

Which statement best describes how this transaction affects existing unsecured bondholders’ credit risk?

• POD and LGD both increase for existing unsecured bondholders because leverage rises and their structural position in the capital structure weakens.
• POD increases but LGD improves because the new secured debt adds more assets to the collateral pool.
• POD is unchanged because operating performance is stable; only equity distribution is affected.

Consider two non-financial issuers with the following simplified data (all amounts in the same currency):

Issuer L ("Liquid")
- Total assets: 1,000
- Net debt (Debt – Cash): 450
- Current ratio: 1.8x
- Unused committed revolver maturing in 3 years: 150
- Next 12-month debt maturities: 200
- EBITDA/Interest: 4.0x

Issuer S ("Solvent but Illiquid")
- Total assets: 1,200
- Net debt: 300
- Current ratio: 0.7x
- No revolvers or committed lines
- Next 12-month debt maturities: 250
- EBITDA/Interest: 5.0x

Assume asset values are realistic and markets are stressed, making new external financing uncertain. Which statement best describes their <em>relative near-term default risk</em> over the next 12 months?

• Issuer L has lower near-term default risk because it has stronger liquidity and committed bank facilities, despite higher net leverage.
• Issuer S has lower near-term default risk because lower net debt always dominates liquidity considerations.
• Both issuers have similar near-term default risk because both have EBITDA/Interest above 3x.

Two BB-rated issuers, Tanco and Insoft, have the same size, industry, and leverage ratios. Each has issued a large secured term loan.

Differences in collateral backing the secured loans:
- Tanco’s term loan is secured by modern manufacturing plants, equipment, and inventories that together are reliably valued above the loan amount in going-concern and liquidation scenarios.
- Insoft’s term loan is secured mainly by trademarks, brand names, and internally developed software, whose recovery values are highly uncertain and difficult to realize in liquidation.

Assume similar POD. Which statement best describes the likely difference in <em>LGD</em> and issue ratings for the secured loans?

• Tanco’s secured loan should have lower LGD and may be notched above the issuer rating.
• Both secured loans should have similar LGD because all secured debt ranks above unsecured debt.
• Insoft’s secured loan should have lower LGD because intangible assets are easier to move across borders.

Two non-financial corporates, A and B, operate in the same stable, non-cyclical industry.

Corporate A
- EBIT margin: 22%
- EBITDA margin: 28%
- Debt/EBITDA: 1.0x
- EBIT/Interest expense: 9.0x
- RCF/Net debt: 45%

Corporate B
- EBIT margin: 14%
- EBITDA margin: 20%
- Debt/EBITDA: 2.5x
- EBIT/Interest expense: 3.5x
- RCF/Net debt: 18%

Assume both companies have similar business models and industry positions. Based strictly on these metrics, which statement best describes the relative credit risk of A and B?

• A has lower probability of default and lower loss given default than B.
• A has lower probability of default, but similar loss given default to B.
• A has similar probability of default, but lower loss given default than B.

A credit analyst reviews a fast-growing issuer that frequently changes auditors, capitalizes many expenses that peers expense immediately, and reports large revenues routed through opaque third-party partners with cash held in offshore escrow accounts. From a debtholder’s perspective, which conclusion is most appropriate?

• These policies mainly affect equity valuation and have limited relevance to credit risk if reported leverage appears moderate.
• These are material governance and accounting red flags that undermine the reliability of reported profitability and cash flow.
• Capitalizing expenses systematically improves true economic performance, reducing default risk relative to peers.

A non-financial corporate issuer plans to fund a major strategic shift into a new technology platform over the next 10–15 years. It has outstanding 180-day commercial paper, 5-year unsecured notes, and 15-year unsecured notes. Assuming the project risk is primarily long term, which instrument’s credit risk is most sensitive to execution risk of the new strategy?

• The 180-day commercial paper, because all instruments share the same probability of default over any horizon.
• The 5-year notes, because they are medium term and therefore always bear the highest business risk exposure.
• The 15-year notes, because later cash flows used for repayment depend most on the success of the new strategy.

You are comparing two industries for their ability to support higher corporate leverage over a full cycle, all else equal.

Industry H (High Capacity):
- High barriers to entry (large capital requirements, regulation).
- Low threat of substitutes.
- Fragmented customer base with low bargaining power.
- Moderate supplier bargaining power.
- Stable long-term demand and limited price competition.

Industry L (Low Capacity):
- Low barriers to entry.
- High threat of substitutes (commoditized product).
- Highly concentrated customers with strong bargaining power.
- Intense industry rivalry, frequent price wars.

Both industries currently have similar macro conditions. Which statement best reflects the link between industry structure and sustainable leverage for a typical issuer?

• Issuers in Industry H can sustainably carry higher leverage because more stable, defensible cash flows support lower POD at a given leverage level.
• Issuers in both industries can carry similar leverage because leverage depends only on firm-specific management decisions, not industry structure.
• Issuers in Industry L can sustainably carry higher leverage because competition forces efficiency gains that offset cash-flow volatility.

A company’s senior unsecured bonds carry an issuer credit rating of B from a major rating agency. The same agency rates the company’s subordinated bond issue two notches lower. Assuming standard practice, which rating is most consistent with this notching approach?

• BB for the subordinated bond, because subordinated debt should compensate investors with a higher rating.
• B for the subordinated bond, because issue ratings for all unsubordinated and subordinated bonds must match the issuer rating.
• B– for the subordinated bond, reflecting higher expected loss from lower priority in the capital structure.

A BB-rated manufacturer with rising probability of default plans a secured bond issue to reduce funding costs. It can pledge either (1) specialized production patents and goodwill, or (2) finished inventory and plant and equipment. From a credit analyst’s perspective, which collateral mix most likely leads to the lowest expected loss for bondholders?

• Patents and goodwill, because intangible assets can have very high franchise value in liquidation.
• Inventory and plant and equipment, because they are tangible assets that can be sold more predictably to offset losses.
• A mix of patents, goodwill, and no tangible assets, because diversification of collateral types always minimizes LGD.

HoldCo Group has the following simplified structure:

- Parent (HoldCo) is a pure holding company with no operations; it owns 100% of OpCo.
- OpCo is the only operating subsidiary and generates virtually all cash flows and owns all operating assets.

Outstanding debt:
- OpCo: 300 of senior unsecured bonds.
- HoldCo: 300 of senior unsecured bonds.

There are no guarantees between HoldCo and OpCo. Assume that in a stress case OpCo’s enterprise value at default is 360 and that liquidation costs and other senior claims are negligible. Which statement best describes expected relative recovery for HoldCo vs OpCo bondholders?

• OpCo senior unsecured bonds will have higher recovery because HoldCo is structurally subordinated to OpCo creditors.
• HoldCo senior unsecured bonds will have higher recovery because they are closer to shareholders in the structure.
• Both sets of bonds will have the same recovery because they are senior unsecured in the same group.