Designing Debt Prof Ian Giddy New York University

Designing Debt Prof. Ian Giddy New York University

First Principles l Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) u Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. u l l Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. u The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. Copyright © 1998 Ian H. Giddy Designing Debt 2

The Agenda What determines the optimal mix of debt and equity for a company? l How does altering the mix of debt and equity affect the value of a company? l What is the right kind of debt for a company? l Copyright © 1998 Ian H. Giddy Designing Debt 3

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING PORTFOLIO CAPITAL M&A Copyright © 1998 Ian

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? You cannot change the value of the real business just by shuffling paper - Modigliani-Miller Copyright © 1998 Ian H. Giddy Designing Debt 8

Corporate Financing Choices: What Kind of Debt? Fixed/floating l Currency of denomination l Maturity or availability l Domestic/Euro l Public/private l Asset-based l Credit enhanced l Swapped l Equity-linked l Copyright © 1998 Ian H. Giddy Designing Debt 9

Ciba-Geigy: What Kind of Debt?

Short Term or Long Term? In 1992, Ciba had fixed assets of SF 13. 9 billion and capital expenditures of SF 1. 9 billion. l Yet the majority of Ciba's debt is in the short-term commercial paper, bank debt, and suppliers-credit markets. l This suggests that if the proportion of debt financing as a whole is increased, much of it should be in the form of longterm debt. l Copyright © 1998 Ian H. Giddy Designing Debt 11

Currency of Denomination of Ciba's Debt? What Should It Be? Geographic location of sales and capital assets. l Currency distribution of sales. l Nature of the company's businesses l Copyright © 1998 Ian H. Giddy Designing Debt 12

Currency of Ciba’s Assets and Debt Geographic distribution of Fixed assets Switzerland 41% 43% U. K. Other Europe Sales 27% Currency distribution of sales 2. 4% Net short position because much of production, but little of sales, here 9% 5. 4% Part of sales effectively U. S. dollar denominated 7% 34. 6% U. S. and Canada 23% 32% 41. 3% Latin America 4% 7% 5. 3% Asia 4% 13% 10. 9% Rest of the world 1% 5% Copyright © 1998 Ian H. Giddy Remarks on economic exposure Estimated currency distribution of debt 21% 54% Most of sales effectively dollar denominated 2% Part of sales effectively U. S. dollar denominated 6% Most of sales effectively dollar denominated 1% Designing Debt 13

What Kind of Debt? Some Considerations l Fixed/floating: u How certain are the cash flows? Are operating profits linked to interest rates or inflation? l Currency: u Consider currency of the assets: currency of denomination vs. currency of location vs. currency of determination. l Maturity or availability: u Are the assets short term or long term? Should the firm assume ease of refinancing, or buy an option on access to financing? Copyright © 1998 Ian H. Giddy Designing Debt 14

Guidelines for Financing Liabilities to match assets: economic exposure of the firm determines base financing choices. l Decision on whether or not to fully match depends on company's view relative to the view implied by market prices. l When strategy is chosen, use the financing/hedging techniques that offer the lowest effective cost. l Copyright © 1998 Ian H. Giddy Designing Debt 15

Designing Debt Start with the Cash Flows on Assets/ Projects Define Debt Characteristics Duration Currency Effect of Inflation Uncertainty about Future Duration/ Maturity Currency Mix Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future Cyclicality & Other Effects Growth Patterns Straight versus Convertible - Convertible if cash flows low now but high exp. growth Special Features on Debt - Options to make cash flows on debt match cash flows on assets Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed Overlay tax preferences Consider ratings agency & analyst concerns Deductibility of cash flows for tax purposes Differences in tax rates across different locales Zero Coupons If tax advantages are large enough, you might override results of previous step Analyst Concerns - Effect on EPS - Value relative to comparables Ratings Agency - Effect on Ratios - Ratios relative to comparables Regulatory Concerns - Measures used Operating Leases MIPs Surplus Notes Can securities be designed that can make these different entities happy? Factor in agency conflicts between stock and bond holders Observability of Cash Flows by Lenders - Less observable cash flows lead to more conflicts Type of Assets financed - Tangible and liquid assets create less agency problems Existing Debt covenants - Restrictions on Financing If agency problems are substantial, consider issuing convertible bonds Consider Information Asymmetries Copyright © 1998 Ian H. Giddy Uncertainty about Future Cashflows - When there is more uncertainty, it may be better to use short term debt Credibility & Quality of the Firm - Firms with credibility problems will issue more short term debt Convertibiles Puttable Bonds Rating Sensitive Notes LYONs Designing Debt 16

Approaches for Evaluating Asset Cash Flows l I. Intuitive Approach Are the projects typically long term or short term? What is the cash flow pattern on projects? u How much growth potential does the firm have relative to current projects? u How cyclical are the cash flows? What specific factors determine the cash flows on projects? u l II. Project Cash Flow Approach Project cash flows on a typical project for the firm u Do scenario analyses on these cash flows, based upon different macro economic scenarios u l III. Historical Data Operating Cash Flows u Firm Value u Copyright © 1998 Ian H. Giddy Designing Debt 17

The Financing Details: Intuitive Approach for Disney Copyright © 1998 Ian H. Giddy Designing

Financing Details: Other Divisions Copyright © 1998 Ian H. Giddy Designing Debt 19

Debt? Equity? What kind?

When Debt and Equity are Not Enough Copyright © 1998 Ian H. Giddy Assets

When Debt and Equity are Not Enough Assets Liabilities Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights Copyright © 1998 Ian H. Giddy What if. . . Claims are inadequate? Returns are inadequate? Designing Debt 23

When Debt and Equity are Not Enough Assets Liabilities Alternatives n Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights Copyright © 1998 Ian H. Giddy n n n Collateralized Asset-securitized Project financing Preferred Warrants Convertible Designing Debt 24

Hybrid Financial Instruments Prof. Ian Giddy New York University

Managing Hybrid Securities Principles of hybrid instruments l Market imperfections as motives for hybrids l Hybrids in the Eurobond market: l u. Asset-backed securities u. Warrant bonds and convertibles u. Index-linked bonds l Application: callable bonds Copyright © 1998 Ian H. Giddy Designing Debt 26

A Day in the Life of the Eurobond Market l Examine the deals u. Why were each done in that particular form? u. What determines the pricing? l Can you break the hybrids into their component parts? Copyright © 1998 Ian H. Giddy Designing Debt 27

A Day in the Life. . . Copyright © 1998 Ian H. Giddy Designing

Equity-Linked Eurobonds l Eurobonds with warrants u. Marui l Convertible Eurobonds u. Battle l

Nikkei-Linked PRINCIPAL REPAYMENT 19, 000 Copyright © 1998 Ian H. Giddy 28, 000 Designing

Economics of Financial Innovation l l l Certain kinds of market imperfections allow hybrids to flourish But innovation are readily copied; so only certain kinds of firm can profit from innovations. There is a product cycle and profitability cycle of innovations. Copyright © 1998 Ian H. Giddy Designing Debt 33

What Conditions Permit Hybrids to Thrive? l Government Rules and Regulations Example: Japan Air Lines Yen-linked Eurobond l Tax Distortions Example: Money Market Preferred l Constraint on Issuers or Investors Example: Nikkei-Linked Eurobond l Segmentation-Driven Innovation Example: Collateralized Mortgage Obligations (CMOs) Copyright © 1998 Ian H. Giddy Designing Debt 34

Structured Notes l l l Bundling and unbundling basic instruments Exploiting market imperfections (sometimes temporary) Creating value added for investor and issuer by tailoring securities to their particular needs Key: For the innovation to work, it must provide value added to both issuer and investor. Copyright © 1998 Ian H. Giddy Designing Debt 35

Medium-Term Notes: Anatomy of a Deal Copyright © 1998 Ian H. Giddy Designing Debt

Anatomy of a Deal Issuer: u. Looking for large amounts of floating-rate USD and DEM funding for its loan porfolio. u. Wants low-cost funds: target CP-. 10 u. Is not too concerned about specific timing of issue, amount or maturity u. Is willing to consider hybrid structures. Copyright © 1998 Ian H. Giddy Designing Debt 37

Anatomy of a Deal Investor: u. Has distinctive preference for high grade investments u. Looking for investments that will improve portfolio returns relative to relevant indexes u. Invests in both floating rate and fixed rate sterling and dollar securities u. Can buy options to hedge portfolio but cannot sell options Copyright © 1998 Ian H. Giddy Designing Debt 38

Anatomy of a Deal Intermediary: u. Has experience and technical and legal background in structure finance u. Has active swap and option trading and positioning capabilities u. Has clients looking for caps and other forms of interest rate protection. Copyright © 1998 Ian H. Giddy Designing Debt 39

The Deal 1 Initiate medium term note programme for the borrower, allowing for a variety of currencies, maturities and special structures 2 Structuring a MTN in such a way as to meet the investor’s needs and constraints 3 Line up all potential counterparties and negociate numbers acceptable to all sides 4 Upon issuer’s and investor’s approval, place the securities Copyright © 1998 Ian H. Giddy Designing Debt 40

The Deal / 2 5 For the issuer, swap and strip the issue into the form of funding that he requires 6 Offer a degree of liquidity to the issuer by standing willing to buy back the securities at a later date. Copyright © 1998 Ian H. Giddy Designing Debt 41

The Issue l l l l Issuer: Deutsche Bank AG Amount: US$ 40 Million Coupon: First three years: semi-annual LIBOR + 3/8% p. a. , paid semi-annually Last 5 years: 8. 35% Price: 100 Maturity: February 10, 2000 Call: Issuer may redeem the notes in full at par on February 10, 1995 Fees: 30 bp Arranger: Credit Swiss First Boston Copyright © 1998 Ian H. Giddy Designing Debt 42

The Parties in the Deal DEUTSCHE SCOTTISH LIFE CSFB Copyright © 1998 Ian H.

What’s Really Going On? Note: l l Issuer has agreed to pay an above-market rate on both the floating rate note and the fixed rate bond segment of the issue FRN portion: . 75 % above normal cost Fixed portion: . 50% above normal cost Issuer has in effect purchased the right to pay a fixed rate of 8. 35% on a five-year bond to be issued in three years time. Copyright © 1998 Ian H. Giddy Designing Debt 48

Motivations for Issuing Hybrid Bonds Company has a view l There are constraints on what the company can issue l The company can arbitrage to save money l Always ask: given my goal, is there an alternative way of achieving the same effect (e. g. , using derivatives? ) l Copyright © 1998 Ian H. Giddy Designing Debt 49

First Principles Again l Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) u Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. u l l Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. u The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. Copyright © 1998 Ian H. Giddy Designing Debt 50