Chartered Financial Analyst Level 2
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- An investor compares a company versus its industry average, using the following data (in $ millions):
| Metric | Company | Industry Average |
|---|---|---|
| EBIT | 9 | 90 |
| Equity market value | 80 | 900 |
| Debt market value | 45 | 360 |
| Interest expense | 2 | 24 |
A synthetic credit rating schedule indicates:
| Credit Rating A | Credit Rating BBB |
|---|---|
| Interest rate coverage (IC) | 4 < IC < 5 |
| Debt-to-equity ratio (D/E) | 30% < D/E < 45% |
Based on this schedule, comparing credit ratings for the company and industry averages suggests that the company achieves:
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A
Lower rating based on IC and a higher rating based on D/E.
B
Higher rating based on IC and a lower rating based on D/E.
C
Higher rating based on both IC and D/E.
Explanation:
Explanation
Let's calculate both metrics for the company and industry average:
Interest Coverage Ratio (IC)
IC = EBIT / Interest Expense
Company:
- EBIT = $9 million
- Interest Expense = $2 million
- IC = 9 / 2 = 4.5
Industry Average:
- EBIT = $90 million
- Interest Expense = $24 million
- IC = 90 / 24 = 3.75
Debt-to-Equity Ratio (D/E)
D/E = Debt Market Value / Equity Market Value
Company:
- Debt Market Value = $45 million
- Equity Market Value = $80 million
- D/E = 45 / 80 = 0.5625 or 56.25%
Industry Average:
- Debt Market Value = $360 million
- Equity Market Value = $900 million
- D/E = 360 / 900 = 0.40 or 40%
Credit Rating Analysis
Interest Coverage (IC):
- Company IC = 4.5 (falls in A rating range: 4 < IC < 5)
- Industry IC = 3.75 (falls in BBB rating range: 3 < IC < 4)
- Company has HIGHER rating than industry based on IC
Debt-to-Equity (D/E):
- Company D/E = 56.25% (falls in BBB rating range: 45% < D/E < 60%)
- Industry D/E = 40% (falls in A rating range: 30% < D/E < 45%)
- Company has LOWER rating than industry based on D/E
Therefore, the company achieves:
- Higher rating based on IC
- Lower rating based on D/E
This corresponds to Option B.
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