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Prof. Ian GiddyNew York University

CorporateFinancial Restructuring:

Summary

Copyright ©2000 Ian H. Giddy Summary 3

What is Corporate Restructuring?

Any substantial change in a company’s financial structure, or ownership or control, or business portfolio.

Designed to increase the value of the firm Restructuring

Improve

capitalization

Change ownership

and control

Improve

debt composition


The Paths to Value Creation

Using the DCF framework, there are four basic ways in which the value of a firm can be enhanced:The cost of capital can be reducedThe cash flows from existing assets to the

firm can be increasedThe expected growth rate in these cash

flows can be increased The length of the high growth period can

be extended.


Getting the Financing Right

Debt

Equity

Short term? Long term? Baht? Dollar? Yen?

Short term? Long term? Baht? Dollar? Yen?

Bonds? Asset-backed? Convertibles? Hybrids?

Bonds? Asset-backed? Convertibles? Hybrids?

Debt/Equity Swaps? Private? Public? Strategic partner? Domestic? ADRs?

Debt/Equity Swaps? Private? Public? Strategic partner? Domestic? ADRs?

Ownership & control? Ownership & control?


The Financing Life Cycle

Operating Leverage

Financial Leverage

Operating Leverage

Financial LeverageSize

Maturity

Information availability


The Wrong Capital Structure: East vs West

VALUE OFTHE

FIRM

DEBT

RATIO

Optimal debt ratio?

Intel TPI

Asia in 5 years?


A Framework for Getting to the Optimal

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > OptimalOverlevered

Actual < OptimalUnderlevered

Is the firm under bankruptcy threat? Is the firm a takeover target?

Yes No

Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

YesTake good projects withnew equity or with retainedearnings.

No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.

Yes No

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

YesTake good projects withdebt.

No

Do your stockholders likedividends?

YesPay Dividends No

Buy back stock

Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.


When The Creditors are Prowling

Time for a Tiger

The financing

is bad

The company

is bad

Business

mix is bad

Raise equity

or

Change debt mix

Change control

or management

through M&A

Sell some businesses

or assets

to pay down debt

Reason

Remedy


The Financing SpectrumE

xpec

ted

Ret

urn

Risk

Senior secured debtSenior secured debt

EquityEquity

Senior unsecured debtSenior unsecured debt

Subordinated debtSubordinated debt

Preferred equityPreferred equity

Convertible debtConvertible debt


What Do Debt-Equity Swaps Do?

Overleverage creates financial distressOverleverage creates financial distress

Actual or potential defaultActual or potential default

Lenders take equity in lieu of repaymentLenders take equity in lieu of repayment

Lenders hold equity passivelyLenders hold equity passively Lenders replace managementLenders replace management Lenders sell equityLenders sell equity

Existing management buys timeExisting management buys time Change of control

means restructuring

Change of control

means restructuring

Financial engineering Bottom line “rationalization” Divestitures & outsourcing

Financial engineering Bottom line “rationalization” Divestitures & outsourcing


Siam Commercial Bank:

Transparency and Disclosure

A 275-page prospectus, which provided a breadth and depth of information previously unseen in an Asian issue.

"We went and looked back at US bank holding company offers - those that were US SEC Grade 3 compliant. We also went back and looked at a lot of the prospectuses for the recaps of US banks, like Mellon and Citibank. We looked at the level of disclosure they achieved and committed ourselves to exceeding that -- which SCB did.“

"When institutions started buying the story, they bought the convertible bonds, the sub debt - you name it, they bought it."


New Equity for Asia

What investors?Portfolio investorsFinancial investorsCorporate investors

What returns should they expect?= Risk-free rate+ Corporate risk+ Financial risk (leverage/debt mismatch)+ “Agency cost” premium+ Country risk

What restructuring?


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?


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


When Debt and Equity are Not Enough

Value

of future

cash flows

Value

of future

cash flows

Contractual int. & principal

No upside

Senior claims

Control via restrictions

Contractual int. & principal

No upside

Senior claims

Control via restrictions

Assets Liabilities

Debt

Residual payments

Upside and downside

Residual claims

Voting control rights

Residual payments

Upside and downside

Residual claims

Voting control rights

Equity

Alternatives

Collateralized Asset-securitized Project financing

Preferred Warrants Convertible


Why Use a Hybrid?

Motivations for Hybrids

Linked to business risk

Linked to

market risk

Cannot hedge

with derivatives

Driven by investor needs

Company hedges

Company does not

hedge

Debt or

equity are

Not good enough


Corporation or Financial Institution requires additional funds to givecustomers financing or to finance a future revenue stream.

Are funds freely available from banks ?

Does the firm/FI have good, self-liquidatingassets ?

Do the assets have a sufficiently high yieldto cover servicing and other costs ?

Would the assets be worth more (have a cheaper all-in funding cost) if they were

isolated from the company/FI ?

Securitize the assets

Borrow frombanks

Issue equity ormezzanine capital

Get out of thefinancingbusiness

Use assets as collateral foron-balancesheet debt

No

Yes

Yes

Yes

Yes

No

No

No

Asset Securitization:The Decision Process


Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF

Expected GrowthReinvestment Rate* Return on Capital

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value= FCFF n+1/(r-gn)

FCFFn.........

Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market Value

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity

Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows

+Beta- Measures market risk X

Risk Premium- Premium for averagerisk investment

Type of Business

Operating Leverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

DISCOUNTED CASHFLOW VALUATION


Private Business: Owner hasall his wealth invested in thebusiness

Venture Capitalist: Haswealth invested in a numberof companies in one sector

Publicly traded companywith investors who are diversified domesticallyorIPO to investors who aredomestically diversified

Publicly traded companywith investors who are diverisified globallyorIPO to global investors

Market Risk

Int’nl Risk

Sector Risk

Competitive Risk

Project Risk

Market Risk

Int’nl Risk

Sector Risk

Competitive Risk

Project Risk

Market Risk

Int’nl Risk

Sector Risk

Competitive Risk

Project Risk

Market Risk

Int’nl Risk

Sector Risk

Competitive Risk

Project Risk

TotalRisk

Risk added to sectorportfolio

Risk added to domestic portfolio

Risk added to global portfolio

StandardDeviation

Beta relative to sector

Beta relative to local index

Beta relative to global index

40%

25%

15%

10%

100/.4=250

100/.25=400

100/.15=667

100/.10=1000

Investor Type Cares about Risk Measure Cost ofEquity

Firm Value

Valuing a Firm from Different Risk PerspectivesFirm is assumed to have a cash flow of 100 each year forever.


The Building Blocks of Valuation

Choose aCash Flow Dividends

Expected Dividends to

Stockholders

Cashflows to Equity

Net Income

- (1- ) (Capital Exp. - Deprec’n)

- (1- ) Change in Work. Capital

= Free Cash flow to Equity (FCFE)

[ = Debt Ratio]

Cashflows to Firm

EBIT (1- tax rate)

- (Capital Exp. - Deprec’n)

- Change in Work. Capital

= Free Cash flow to Firm (FCFF)

& A Discount Rate Cost of Equity

Basis: The riskier the investment, the greater is the cost of equity.

Models:

CAPM: Riskfree Rate + Beta (Risk Premium)

APM: Riskfree Rate + Betaj (Risk Premiumj): n factors

Cost of Capital

WACC = ke ( E/ (D+E))

+ kd ( D/(D+E))

kd = Current Borrowing Rate (1-t)

E,D: Mkt Val of Equity and Debt

& a growth pattern

t

g

Stable Growth

g

Two-Stage Growth

|High Growth Stable

g

Three-Stage Growth

|High Growth StableTransition


A Framework for Analyzing Companies with Negative or Abnormally Low Earnings

Why are the earnings negative or abnormally low?

TemporaryProblems

Cyclicality:Eg. Auto firmin recession

StructuralProblems: Eg. Cable co. with high infrastruccture investments.

LeverageProblems: Eg. An otherwise healthy firm with too much debt.

Long-termOperatingProblems: Eg. A firm with significant production or cost problems.

Normalize Earnings

Value the firm by doing detailed cash flow forecasts starting with revenues and reduce or eliminate the problem over time.:(a) If problem is structural: Target for operating margins of stable firms in the sector.(b) If problem is leverage: Target for a debt ratio that the firm will be comfortable with by end of period, which could be its own optimal or the industry average.(c) If problem is operating: Target for an industry-average operating margin.

If firm’s size has notchanged significantlyover time

Average DollarEarnings (Net Income if Equity and EBIT if Firm made bythe firm over time

If firm’s size has changedover time

Use firm’s average ROE (if valuing equity) or average ROC (if valuing firm) on current BV of equity (if ROE) or current BV of capital (if ROC)


What’s a Company Worth?The Options Approach

Present Value of Expected Cash Flows if Option Excercised

Value of the Firm or project

The Value Enhancement ChainGimme’ Odds on. Could work if..

Assets in Place 1. Divest assets/projects withDivestiture Value >

Continuing Value2. Terminate projects with

Liquidation Value >

Continuing Value3. Eliminate operating

expenses that generate nocurrent revenues and no

growth.

1. Reduce net working capitalrequirements, by reducing

inventory and accountsreceivable, or by increasingaccounts payable.

2. Reduce capital maintenanceexpenditures on assets in

place.

1. Change pricing strategy tomaximize the product of

profit margins and turnoverratio.

Expected Growth Eliminate new capital

expenditures that are expected

to earn less than the cost ofcapital

Increase reinvestment rate or

marginal return on capital or

both in firm’s existingbusinesses.

Increase reinvestment rate or

marginal return on capital or

both in new businesses.

Length of High Growth Period If any of the firm’s products orservices can be patented and

protected, do so

Use economies of scale or costadvantages to create higher

return on capital.

1. Build up brand name2. Increase the cost of

switching from product andreduce cost of switching to

it.

Cost of Financing 1. Use swaps and derivativesto match debt more closely

to firm’s assets2. Recapitalize to move the

firm towards its optimaldebt ratio.

1. Change financing type anduse innovative securities to

reflect the types of assetsbeing financed

2. Use the optimal financingmix to finance new

investments.3. Make cost structure more

flexible to reduce operatingleverage.

Reduce the operating risk of thefirm, by making products less

discretionary to customers.


Ipoh-KelantanIpoh-Kelantan

Ipoh Kelantan Combined Synergy Optimal DebtGrowth 5% 5% 5% 6% 6%Tax rate 35% 35% 35% 35% 35%Initial Revenues 4400 3125 7525 7525 7525COGS 87.50% 89% 86.00% 86.00%WC 10% 10% 10% 10% 10%Beta 1.70 1.50 1.40 1.40 1.51 Cost of debt 8.50% 8.50% 7.75% 7.75% 8.00%Equity Market Value 2000 1300 3300 3300 2968Debt Market Value 160 250 410 410 742

T+1 T+1 T+1 T+1Revenues 4620 3281 7901 7977 7977-COGS 4043 2920 6963 6860 6860-Depreciation 200 74 274 274 274=EBIT 378 287 664 843 843EBIT(1-Tax) 245 187 432 548 548+Depreciation 200 74 274 274 274-CapEx -180 -67 -247 -247 -247-Change in WC -22 -16 -38 -45 -45-Free Cash Flow to Firm 243 178 422 530 530Cost of Equity (from CAPM) 16.35% 15.25% 14.70% 14.70% 15.28%Cost of Debt 5.53% 5.53% 5.04% 5.04% 5.20%WACC 15.55% 13.68% 13.63% 13.63% 13.27%

Firm Value 2307 2054 4885 6944 7294Equity Value 2147 1804 4475 6534 6552 TotalIncrease 2060 18 2078

101%


The Gains From an Acquisition

Gains from merger

Synergies Control

Top line Financial

restructuring

Business

Restructuring

(M&A)

Bottom line


The Final Question

How do we get paid?How do we get paid?

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