DBS Bank Corporate Financial Restructuring Prof Ian Giddy

DBS Bank Corporate Financial Restructuring Prof. Ian Giddy New York University

Why Financial Restructuring? The Asian Bet l The Solution, Part I: Recapitalization l The Solution, Part II: Financial Restructuring l The Solution, Part III: Corporate Restructuring l Copyright © 2000 Ian H. Giddy Recapitalization 2

The Asian Bet High growth disguised speculative financing structures l Governments shielded companies and banks from capital market discipline l Too much debt l Too much foreign-currency debt l Closely held ownership relying on reinvested earnings l Copyright © 2000 Ian H. Giddy Recapitalization 3

The Asian Bet High growth disguised speculative financing structures The three excesses l Governments shielded companies and n Too much debt discipline banks from capital market n Too l Too much debtmuch labor n Too much capacity l Too much foreign-currency debt l Closely held ownership relying on reinvested earnings l Copyright © 2000 Ian H. Giddy Recapitalization 4

How the Bet was Lost Vulnerable economies, newly liberalized, succumbed to currency crises l Economic downturns followed l Companies were unable to service even domestic debt, never mind foreign currency debt l Still unreformed, many Asian companies remain misfinanced l Copyright © 2000 Ian H. Giddy Recapitalization 5

What is Corporate Restructuring? Any substantial change in a company’s financial structure, or ownership or control, or business portfolio. l Designed to increase the value of the firm Restructuring l Improve capitalization Copyright © 2000 Ian H. Giddy Improve debt composition Change ownership and control Recapitalization 6

It’s All About Value l How can corporate and financial restructuring create value? Assets Fix the business Copyright © 2000 Ian H. Giddy Operating Cash Flows Liabilities Debt Or fix the financing Equity Recapitalization 7

Restructuring Figure out what the business is worth now Use valuation model – present value of free cash flows Fix the business mix – divestitures Value assets to be sold Fix the business – strategic partner or merger Value the merged firm with synergies Fix the financing – improve D/E structure Revalue firm under different leverage assumptions – lowest WACC Fix the kind of equity What can be done to make the equity more valuable to investors? Fix the kind of debt or hybrid financing What mix of debt is best suited to this business? Fix management or control Value the changes new control would produce Copyright © 2000 Ian H. Giddy Recapitalization 8

DBS Bank Corporate Recapitalization Prof. Ian Giddy New York University

Getting the Financing Right Step 1: The Proportion of Equity & Debt n Equity Copyright © 2000 Ian H. Giddy Achieve lowest weighted average cost of capital May also affect the business side Recapitalization 10

Getting the Financing Right Step 2: The Kind of Equity & Debt n n Equity Bonds? Asset-backed? Convertibles? Hybrids? n Debt/Equity Swaps? Private? Public? Strategic partner? Domestic? ADRs? n Ownership & control? n n n Copyright © 2000 Ian H. Giddy Short term? Long term? Baht? Dollar? Yen? Recapitalization 11

Does Capital Structure Matter? Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm =D+E You cannot change the value of the real business just by shuffling paper - Modigliani-Miller Copyright © 2000 Ian H. Giddy Recapitalization 12

Most Value is Created on the Asset Side Only invest in assets (or keep assets) where ROE>required return on equity l Value-Based Management for performance evaluation l Union Camp: Packaging Business ? Copyright © 2000 Ian H. Giddy Recapitalization 13

Does Capital Structure Matter? Yes! Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) COST OF CAPITAL Copyright © 2000 Ian H. Giddy Debt Equity Value of the firm =D+E Optimal debt ratio? DEBT RATIO Recapitalization 14

Does Capital Structure Matter? Yes! Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) VALUE OFTHE FIRM Copyright © 2000 Ian H. Giddy Debt Equity Value of the firm =D+E Optimal debt ratio? DEBT RATIO Recapitalization 15

Does Capital Structure Matter? Yes! Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm =D+E Value of Firm = PV(Cash Flows) + PV(Tax Shield) - Distress Costs Copyright © 2000 Ian H. Giddy Recapitalization 16

Changing Financial Mix l l l Debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt. Taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile). The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more debt. Copyright © 2000 Ian H. Giddy Recapitalization 17

Debt: Pros and Cons Advantages of Borrowing Disadvantages of Borrowing 1. Tax Benefit: 1. Bankruptcy Cost: Higher tax rates --> Higher tax benefit Higher business risk --> Higher Cost 2. Added Discipline: 2. Agency Cost: Greater the separation between managers Greater the separation between stock- and stockholders --> Greater the benefit holders & lenders --> Higher Cost 3. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost Copyright © 2000 Ian H. Giddy Recapitalization 18

See Saw Business Uncertainty Operating Leverage Financial Risk Financial Leverage Copyright © 2000 Ian

Young and Old Financial Leverage Size Operating Leverage Financial Leverage Maturity Copyright © 2000

Disney WACC Weighted Average Cost of Capital and Debt Ratios 11. 40% 11. 20% 11. 00% 10. 80% 10. 60% 10. 40% 10. 20% 10. 00% 9. 80% 9. 60% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0 9. 40% Debt Ratio Copyright © 2000 Ian H. Giddy Recapitalization 21

Siderar: Steel Company in Argentina Copyright © 2000 Ian H. Giddy Recapitalization 22

Capital Structure: East vs West Intel VALUE OFTHE FIRM TPI Optimal debt ratio? DEBT

Case Study: Sammi Steel 1989 Acquisition of Atlas Copyright © 2000 Ian H. Giddy

Perceived Benefits to Sammi From Acquisition of Atlas Steel l Achieve $280 mm savings by acquiring Atlas Steel and related companies u. Cost of setting up own production facility would have been $500 mm u. Savings were channeled into restructuring production facilities at existing plants l Sammi’s share price rose 9% on news of strategic acquisitions Copyright © 2000 Ian H. Giddy Recapitalization 25

How Should the Acquisition Have Been Financed? Assets added: $210 million Copyright © 2000 Ian H. Giddy Debt added: $210 million (C$250 m) Loan: C$180 m Ret earn: C$70 m Plus w. cap. : Eurobond with warrants US$50 m Recapitalization 27

Problems faced by Sammi from the Acquisition l l l Post acquisition debt-equity ratio soared from below 1: 1 to 2: 1, above industry averages Future refinancing of debt caused earnings after interest costs to fall 17% Purchase price of $210. 6 mm found to have been excessive The acquisition was ill-timed Existing and new plants suffered from low capacity utilization of around 65% Copyright © 2000 Ian H. Giddy Recapitalization 28

Sammi Steel in 1995 l l l l Sammi Atlas pushed to raise productivity by 15% A leaner organization: Work force had shrunk by 19. 4% since 1988 4 year freezes on salaries to limit labor costs Unrelated and unprofitable businesses have been sold off New export zones identified in China and South. East Asia Conversion of debt into equity to reduce interest costs by 6%; Result: dilution in EPS, unless offset by increased volume of sales Copyright © 2000 Ian H. Giddy Recapitalization 29

Analysis of Change in Value of Sammi Steel Copyright © 2000 Ian H. Giddy

March 1997 Sammi Steel is bankrupt! Copyright © 2000 Ian H. Giddy Recapitalization 31

March 1997 Sammi Steel is bankrupt! Dr F R Structuring n Diagnosis n Prevention

Financing Choices Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) From How much debt? to What kind of debt? and What kind of equity? You can make a difference - Pepper-Giddy Copyright © 2000 Ian H. Giddy Recapitalization 33

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING PORTFOLIO CAPITAL M&A Copyright © 2000 Ian

Appendix: Costs and Benefits of Debt l Benefits of Debt u. Tax Benefits u. Adds discipline to management l Costs of Debt u. Bankruptcy Costs u. Agency Costs u. Loss of Future Flexibility Copyright © 2000 Ian H. Giddy Recapitalization 38

Tax Benefits of Debt l Tax Benefits: Interest on debt is tax deductible whereas cash flows on equity (like dividends) are not. u. Tax benefit each year = t r B u. After tax interest rate of debt = (1 -t) r l Other things being equal, the higher the marginal tax rate of a corporation, the more debt it will have in its capital structure. Copyright © 2000 Ian H. Giddy Recapitalization 39

Debt Adds Discipline to Management Equity is a cushion; Debt is a sword; l The management of firms which have high cash flows left over each year are more likely to be complacent and inefficient. l Copyright © 2000 Ian H. Giddy Recapitalization 40

Bankruptcy Cost l The expected bankruptcy cost is a function of two variables-u the cost of going bankrupt q direct costs: Legal and other Deadweight Costs q indirect costs: Lost Sales. . . üdurable versus non-durable goods (cars) üquality/safety is important (airlines) üsupplementary services (copiers) uthe Copyright © 2000 Ian H. Giddy probability of bankruptcy Recapitalization 41

The Bankruptcy Cost Proposition l Other things being equal, the greater the implicit bankruptcy cost and/or probability of bankruptcy in the operating cash flows of the firm, the less debt the firm can afford to use. Copyright © 2000 Ian H. Giddy Recapitalization 42

Agency Cost: Lenders’ Rights l Stockholders incentives are different from bondholder incentives u. Taking on risky projects u. Withholding information u. Paying large dividends l Other things being equal, the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use. Copyright © 2000 Ian H. Giddy Recapitalization 43

Loss of Future Financing Flexibility When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt. l Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects. l Copyright © 2000 Ian H. Giddy Recapitalization 44