Prof. Ian Giddy New York University Designing Debt.

Prof. Ian GiddyNew York University

Designing Debt

Copyright ©1998 Ian H. Giddy Designing Debt 2

First Principles

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)

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.

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. The form of returns - dividends and stock buybacks - will depend

upon the stockholders’ characteristics.


The Agenda

What determines the optimal mix of debt and equity for a company?

How does altering the mix of debt and equity affect the value of a company?

What is the right kind of debt for a company?


Corporate Finance

CORPORATE FINANCE

DECISONS

CORPORATE FINANCE

DECISONS

INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT


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


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

Ciba-Geigy: What Kind of Debt?


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.


Geographic location of sales and capital assets.

Currency distribution of sales. Nature of the company's businesses

Currency of Denomination of Ciba's Debt? What Should It Be?


Currency of Ciba’s Assets and Debt

Geographic distributionof

Currencydistribution

of sales Remarks on economic exposure

Estimatedcurrency

distribution ofdebt

Fixedassets Sales

Switzerland 41%

43%

2.4% Net short position because much ofproduction, but little of sales, here

9%

U.K.

27%

5.4% Part of sales effectively U.S. dollardenominated

7%

OtherEurope

34.6% 21%

U.S. andCanada

23% 32% 41.3% 54%

LatinAmerica

4% 7% 5.3% Most of sales effectively dollardenominated

2%

Asia 4% 13% 10.9% Part of sales effectively U.S. dollardenominated

6%

Rest of theworld

1% 5% Most of sales effectively dollardenominated

1%

Geographic distributionof

Currencydistribution

of sales Remarks on economic exposure

Estimatedcurrency

distribution ofdebt

Fixedassets Sales

Switzerland 41%

2.4% Net short position because much ofproduction, but little of sales, here

9%

U.K.

27%

5.4% Part of sales effectively U.S. dollardenominated

7%

OtherEurope

34.6% 21%

U.S. andCanada

23% 32% 41.3% 54%

LatinAmerica

4% 7% 5.3% Most of sales effectively dollardenominated

2%

Asia 4% 13% 10.9% Part of sales effectively U.S. dollardenominated

6%

Rest of theworld

1% 5% Most of sales effectively dollardenominated

1%


What Kind of Debt? Some Considerations 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?


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.


Designing Debt

Duration Currency Effect of InflationUncertainty about Future

Growth PatternsCyclicality &Other Effects

Define DebtCharacteristics

Duration/Maturity

CurrencyMix

Fixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future

Straight versusConvertible- Convertible ifcash flows low now but highexp. growth

Special Featureson Debt- Options to make cash flows on debt match cash flows on assets

Start with the Cash Flowson Assets/Projects

Overlay taxpreferences

Deductibility of cash flowsfor tax purposes

Differences in tax ratesacross different locales

Consider ratings agency& analyst concerns

Analyst Concerns- Effect on EPS- Value relative to comparables

Ratings Agency- Effect on Ratios- Ratios relative to comparables

Regulatory Concerns- Measures used

Factor in agencyconflicts between stockand bond holders

Observability of Cash Flowsby 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

Consider Information Asymmetries

Uncertainty about Future Cashflows- When there is more uncertainty, itmay be better to use short term debt

Credibility & Quality of the Firm- Firms with credibility problemswill issue more short term debt

If agency problems are substantial, consider issuing convertible bonds

Can securities be designed that can make these different entities happy?

If tax advantages are large enough, you might override results of previous step

Zero Coupons

Operating LeasesMIPsSurplus Notes

ConvertibilesPuttable BondsRating Sensitive

NotesLYONs

Commodity BondsCatastrophe Notes

Design debt to have cash flows that match up to cash flows on the assets financed


Approaches for Evaluating Asset Cash Flows

I. Intuitive Approach Are the projects typically long term or short term? What is the

cash flow pattern on projects? How much growth potential does the firm have relative to

current projects? How cyclical are the cash flows? What specific factors

determine the cash flows on projects?

II. Project Cash Flow Approach Project cash flows on a typical project for the firm Do scenario analyses on these cash flows, based upon

different macro economic scenarios

III. Historical Data Operating Cash Flows Firm Value


The Financing Details: Intuitive Approach for Disney

Business Project Cash Flow Characteristics Type of Financing

Creative

Content

Projects are likely to

1. be short term

2. have cash outflows are primarily in dollars (but cash inflows

could have a substantial foreign currency component

3. have net cash flows which are heavily driven by whether the

movie or T.V series is a “hit”

Debt should be

1. short term

2. primarily dollar

3. if possible, tied to the

success of movies.

Retailing Projects are likely to be

1. medium term (tied to store life)

2. primarily in dollars (most in US still)

3. cyclical

Debt should be in the form

of operating leases.

Broadcasting Projects are likely to be

1. short term

2. primarily in dollars, though foreign component is growing

3. driven by advertising revenues and show success

Debt should be

1. short term

2. primarily dollar debt

3. if possible, linked to

network ratings.


Financing Details: Other Divisions

Theme Parks Projects are likely to be

1. very long term

2. pr imarily in dollars, but a significant proportion of revenues

come from foreign tourists.

3. affected by success of movie and broadcasting divisions.

Debt should be

1. long term

2. mix of currencies, based

upon tourist make up.

Real Estate Projects are likely to be

1. long term

2. pr imarily in dollars.

3. affected by real estate values in the area

Debt should be

1. long term

2. dollars

3. real-estate linked

(Mortgage Bonds)

FINANCING ALTERNATIVES AVAILABLE TO MAJOR CORPORATIONS

DEBT

EQUITY

Subsidized funds

Privateplacement

Publicoffering

Revolvingfacility

Term loan

Real estate

Leasing

Assetbacked

Unsecured

Domestic

Eurobond

Fixed

Floating

Longterm

Shortterm

US CP

Euro CP

Bank debt

MTN

Dollar

Non-dollar

ARPFRN

VRN

StraightHybrid

Callable

Index-linked

Convertible

With warrants

Restricted

Full rights

Private sale

Public offering

Domestic

International

Equity options

Stripped

Unstripped

Projectfinance

Bankdebt

Debt?

Equity?

What kind?

Debt?

Equity?

What kind?


When Debt and Equity are Not Enough

Value

of future

cash flows

Value

of future

cash flows

Claims on

the cash flows

Claims on

the cash flows

Assets Liabilities



Value

of future

cash flows

Value

of future

cash flows

Contractual int. & principal

No upside

Senior claims

Control via restrictions


No upside

Senior claims


Assets Liabilities

Debt

Residual payments

Upside and downside

Residual claims

Voting control rights

Residual payments

Upside and downside

Residual claims


Equity

What if...

Claims

are inadequate?

Returns

are inadequate?



Value

of future

cash flows

Value

of future

cash flows


No upside

Senior claims



No upside

Senior claims


Assets Liabilities

Debt

Residual payments

Upside and downside

Residual claims


Residual payments

Upside and downside

Residual claims


Equity

Alternatives

Collateralized Asset-securitized Project financing

Preferred Warrants Convertible

Prof. Ian Giddy

New York University

Hybrid Financial Instruments


Managing Hybrid Securities

Principles of hybrid instruments Market imperfections as motives for

hybrids Hybrids in the Eurobond market:

Asset-backed securitiesWarrant bonds and convertiblesIndex-linked bonds

Application: callable bonds


A Day in the Lifeof the Eurobond Market

Examine the dealsWhy were each done in that particular

form?What determines the pricing?

Can you break the hybrids into their component parts?


A Day in the Life...

NEW INTER NA TIONAL BO ND ISSUES

Bo rrowerBo rrower Amou nt m .Amou nt m . Cou pon %Cou pon % PricePr ice Mat ur ityMat ur ity FeesFees Boo k ru nn erBoo k ru nn er

Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse

Marui Corp* US$500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nomura

Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB

Battle Mountaingold US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch

SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF

Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L

Eurofima (a ) Pta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank

Ir ish Bldg Soc . (a ) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IBJ

Bank of Montreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit

¶Final te rms. *With equity warrants. Private placement. Convertible. (a) Non-callable. (b) Callable at par af ter 5 years. I f call notexercised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .







SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF












SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF












SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF







Equity-Linked Eurobonds

Eurobonds with warrantsMarui

Convertible EurobondsBattle Mountaingold

Index-linked EurobondsBank of Montreal


Warrants

TheoreticalValue

Market ValueMarket Premium

Value

of

Warrant

($)

0Price Per Share of Common Stock ($)


Convertibles

ConversionValue

StraightBond Value

Market ValueMarket Premium

Value

of

Convertible

Bond

($) 0

Price Per Share of Common Stock


Nikkei-Linked

28,00019,000

PRINCIPAL

REPAYMENT


Economics of Financial Innovation

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.


What Conditions Permit Hybrids to Thrive?

Government Rules and RegulationsExample: Japan Air Lines Yen-linked Eurobond

Tax DistortionsExample: Money Market Preferred

Constraint on Issuers or InvestorsExample: Nikkei-Linked Eurobond

Segmentation-Driven InnovationExample: Collateralized Mortgage Obligations

(CMOs)


Structured Notes

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.


Medium-Term Notes:Anatomy of a Deal


Anatomy of a Deal

Issuer:Looking for large amounts of floating-rate

USD and DEM funding for its loan porfolio.Wants low-cost funds: target CP-.10Is not too concerned about specific timing

of issue, amount or maturityIs willing to consider hybrid structures.


Anatomy of a Deal

Investor:Has distinctive preference for high grade

investmentsLooking for investments that will improve

portfolio returns relative to relevant indexesInvests in both floating rate and fixed rate

sterling and dollar securitiesCan buy options to hedge portfolio but

cannot sell options


Anatomy of a Deal

Intermediary:Has experience and technical and legal

background in structure financeHas active swap and option trading and

positioning capabilitiesHas clients looking for caps and other

forms of interest rate protection.


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


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.


The Issue

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


The Parties in the Deal

SCOTTISH

LIFE

CSFB

DEUTSCHE


What’s Really Going On?

Note: 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.


Motivations for Issuing Hybrid Bonds

Company has a view There are constraints on what the

company can issue The company can arbitrage to save

money Always ask: given my goal, is there an

alternative way of achieving the same effect (e.g., using derivatives?)


First Principles Again

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)

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.

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. The form of returns - dividends and stock buybacks - will depend

upon the stockholders’ characteristics.


www.giddy.org

Ian Giddy

NYU Stern School of Business

Tel 212-998-0332; Fax 212-995-4233

[email protected]

http://www.giddy.org

Prof. Ian Giddy New York University Designing Debt.

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