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Designing Debt

Designing Debt. DBS Bank. Prof. Ian Giddy New York University. Designing Debt: Match the Business. Fixed/floating: How certain are the cash flows? Are operating profits linked to interest rates or inflation? Currency:

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Designing Debt

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  1. Designing Debt DBS Bank Prof. Ian Giddy New York University

  2. Designing Debt: Match the Business • Fixed/floating: • How certain are the cash flows? Are operating profits linked to interest rates or inflation? • Currency: • Consider currency of the assets: currency of denomination vs. currency of location vs. currency of determination. • Maturity or availability: • Are the assets short term or long term? Should the firm assume ease of refinancing, or buy an option on access to financing?

  3. Measuring Market Exposure • Defining corporate exposure: “How will my company’s value be affected by market price fluctuations?” • Types of exposure • Transactions • Balance sheet/portfolio • Economic • A risk management framework

  4. Identification and Definition of Financial Exposures Goal: To identify significant financial risk exposures and prioritize them in a manner consistent with management's desired risk profile. Translation Exposure, Transaction Exposure, and Economic Exposure Absolute Rate Risk, Convexity, Basis or Correlation Risk Price Risk, Basis or Correlation Risk • Short-term liquidity portfolio • Investment portfolio • Capital markets borrowing • Leasing portfolio • Long-term versus short-term exposure • Intracompany versus third party exposure • Cross currency exposure • Competitive exposures • Procurement • Inventory • Sales elasticity Commodity Interest Rate Currency

  5. Market Risks: Definitions Three Views of Market Price Risk: • Transactions • Balance Sheet/Portfolio • Economic risk.

  6. Market Risks: Definitions Three Views of Market Price Risk: • Transactions • Balance Sheet/Portfolio • Economic risk. Transactions Exposure Portfolio Exposure Economic Exposure

  7. Transactions Exposure Portfolio Exposure Economic Exposure Transactions Exposure • Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain date • Example: If Nokia invoices a NTT of Japan in Japanese yen for a celphone shipment then the firm has Japanese yen exposure and can hedge this by borrowing yen. • This kind of exposure is readily hedgable using forwards, futures or debt

  8. Transactions Exposure Portfolio Exposure Economic Exposure But Transactions Exposure Can be Misleading... • Austin Computer purchases notebook computers in Taiwan for sale in the US. • Austin must pay in NT$. • Should it hedge its anticipated payments for 1996?

  9. Transactions Exposure Portfolio Exposure Economic Exposure Austin Computer NT$

  10. Photronics: Translation Exposure

  11. Economic Exposure • Economic exposure is how the firm’s revenues and costs will respond to exchange rate changes. • Example: Even though Intel invoices German customers in marks, its future revenues may be unaffected by fluctuations in the mark if the currency of determination of prices in the semiconductor business is the dollar or even the yen. • The currency of determination is the currency in which most of the competition prices similar products.

  12. Salmon for Chile • Exporting salmon from Chile to Japan; finance in • Pesos? • Dollars? • Yen? • Krone?

  13. Ciba-Geigy

  14. Case Study: Financing Ciba 1) What is Ciba's debt-to-equity ratio, and what might one advise the company about what it should be? (2) How much of Ciba's debt is fixed-rate borrowing, and should this proportion change? (3) How much of the company's debt should be long term? (4) What is the composition, by currency, of Ciba's debt? What should it be?

  15. Case Study: Financing Ciba Could Ciba benefit from more debt? • Tax shield? Could Ciba be hurt by more debt? • Risks of financial distress? • Costs of financial distress? • Reduce flexibility?

  16. Ciba: How Much Debt?

  17. Ciba: Are Revenues Stable? Ciba Sales and Earnings (in billions of Swiss francs) 100 10 1 Legend Sales Profits 0.1 1982 1984 1986 1988 1990 1992

  18. 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? Financing Choices You cannot change the value of the real business just by shuffling paper - Modigliani-Miller

  19. Corporate Financing Choices:What Kind of Debt? • Fixed/floating • Currency of denomination • Maturity or availability • Domestic/Euro • Public/private • Asset-based • Credit enhanced • Swapped • Equity-linked

  20. Short Term or Long Term? • In 1992, Ciba had fixed assets of SF13.9 billion and capital expenditures of SF1.9 billion. • Yet the majority of Ciba's debt is in the short-term commercial paper, bank debt, and suppliers-credit markets. • This suggests that if the proportion of debt financing as a whole is increased, much of it should be in the form of long-term debt.

  21. Currency of Denomination of Ciba's Debt? What Should It Be? • Geographic location of sales and capital assets. • Currency distribution of sales. • Nature of the company's businesses

  22. Currency of Ciba’s Assets and Debt Geographic distribution Geographic distribution Estimated Estimated of of Currency Currency currency currency Fixed Fixed distribution distribution distribution of distribution of Sales Sales Remarks on economic exposure Remarks on economic exposure assets assets of sales of sales debt debt Switzerland Switzerland 41% 41% 2.4% 2.4% Net short position because much of Net short position because much of 9% 9% production, but little of sales, here production, but little of sales, here 43% U.K. U.K.   5.4% 5.4% Part of sales effectively U.S. dollar Part of sales effectively U.S. dollar 7% 7% denominated denominated   27% 27% Other Other 34.6% 34.6% 21% 21% Europe Europe U.S. and U.S. and 23% 23% 32% 32% 41.3% 41.3% 54% 54% Canada Canada Latin Latin 4% 4% 7% 7% 5.3% 5.3% Most of sales effectively dollar Most of sales effectively dollar 2% 2% America America denominated denominated Asia Asia 4% 4% 13% 13% 10.9% 10.9% Part of sales effectively U.S. dollar Part of sales effectively U.S. dollar 6% 6% denominated denominated Rest of the Rest of the 1% 1% 5% 5% Most of sales effectively dollar Most of sales effectively dollar 1% 1% world world denominated denominated

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

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

  25. Ban Pu • How much debt in relation to equity should Ban Pu have? • Should the debt be fixed or floating? • How much of the company's debt should be long term? • What should be the currency composition of its debt? • Why a convertible? • How should its financing change over the company’s life cycle?

  26. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT PORTFOLIO MEASUREMENT CAPITAL DEBT EQUITY TOOLS M&A

  27. Operating Leverage Financial Leverage Operating Leverage Financial Leverage Young and Old Size Maturity

  28. Operating Leverage Financial Leverage Operating Leverage Financial Leverage Domestic and Global Size Maturity

  29. Asian Companies:Life-Cycle Financing DOMESTIC BANK DEBT D E B T DOMESTIC PUBLIC BONDS AND PAPER EURO, FOREIGN, AND GLOBAL BONDS MEDIUM- TERM NOTE AND CP PROGRAMS E Q U I T Y FAMILY OR STATE OWNERSHIP DOMESTIC PUBLIC EQUITY LIMITED FOREIGN EQUITY GLOBAL EQUITY

  30. Corporate Financing Choices • Do financing choices matter? • Debt or equity? • What kind of debt? Certain kinds of market imperfections allow corporations to reduce costs by improving the financing mix

  31. Corporate Financing Choices • Do financing choices matter? • Debt or equity? • What kind of debt? Certain kinds of market imperfections allow corporations to reduce costs by improving the financing mix IMPLEMENTATION

  32. Banpu

  33. Corporate Financing Choices:What Kind of Debt for Banpu? • Fixed/floating • Currency of denomination • Maturity or availability • Domestic/Euro • Straight/convertible

  34. Banpu: Capital Structure

  35. Banpu: Capital Structure

  36. Interest Rate Riskand Financing Choices Prof. Ian Giddy New York University

  37. Financial Risk Management • Why does it matter? • Why and when should we hedge? • What should we hedge? How should we gauge exposure? • Financial risk management must be tied to the company’s business

  38. IBM’s Interest Rate Exposure

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

  40. What is a Corporation’s Sensitivity to Interest Rate Changes? • The answer to this question is important because it • it provides a measure of the duration of the firm’s projects • it provides insight into whether the firm should be using fixed or floating rate debt.

  41. Interest Rate Risk:Portfolio • Portfolio risk: interest rate fluctuations can affect the value of a bond investment portfolio • Bond price fluctuations will affect the balance sheet • Can be hedged, using duration as a risk/sensitivity measurement tool • Can be hedged with futures, bond options, and swaps.

  42. Assets (each $10m): 2-year GNMA 6-year, 8% T-note 12-year asset-backed corporate Pension liabilities: $100m 2 years $120m 5 years $85m 10 years Pepsico Pension • What is Pepsico pension fund’s risk? • Duration of the assets (+ve) • Duration of the liabilities (-ve) • Net duration is the risk to be hedged!

  43. Pension Fund, simplified Assets (each $10m): • 1-year E$ deposit • 5-year, 6% T-note Duration=4.6 • 9-year Strip Fixed liabilities: • $10m 3 years • $10m 5 years • $10m 7 years • Pension Fund’s risk? • Asset Duration = 10(1%)+10(4.6%)+10(9%) • Liab Duration = 10(3%)+10(5%)+10(7%) • Net duration is 1.46-1.50 = -4m

  44. Interest Rate Risk: Economic • Economic risk arises from the real business risk of the company, insofar as it is tied to market interest rates • It affects the shareholder value, but may be difficult to quantify • It can often be hedged using forwards, futures or interest-rate swaps. • Example: Cincinnati Constr. Co. uses collar to hedge its interest cost; this is consistent with its business risk.

  45. Three Views of Interest Rate Risk Transactions Exposure Portfolio Exposure Economic Exposure

  46. Assignment

  47. Aero Lloyd • Aero Lloyd is wants to benefit from lower rates but is afraid of a higher cost of funds in the future. Should it: • Convert the Vereinsbank line into a 3-year fixed rate term loan at 8.85% • Fix Aero Lloyd's short-term cost of funds by means of a 3-month FRA , starting in three months. • Hedge against rising interest rates using interest rate futures. • Renegotiate the leases at a floating rate. • Convert Aero Lloyd's cost of funds into floating by means of an interest rate swap. The 3-year swap rate was 6.97%. • Do nothing at present?

  48. Aero Lloyd

  49. Conclusion • Fixed/floating: • How certain are the cash flows? Are operating profits linked to interest rates or inflation? • Currency: • Consider currency of the assets: currency of denomination vs. currency of location vs. currency of determination. • Maturity or availability: • Are the assets short term or long term? Should the firm assume ease of refinancing, or buy an option on access to financing?

  50. Managing Financial Risk:Case Study Prof. Ian Giddy New York University

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