SIM Designing Debt.ppt
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  • How much has firm value changed for a given change in interest rates?

SIM Designing Debt.ppt Presentation Transcript

  • 1. Prof. Ian Giddy New York University Designing Debt SIM/NYU The Job of the CFO
  • 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. Market Risks: Definitions
    • Three Views of
    • Market Price Risk:
      • Transactions
      • Balance Sheet/Portfolio
      • Economic risk.
    Transactions Exposure Portfolio Exposure Economic Exposure
  • 4. Ciba-Geigy
  • 5. 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?
  • 6. 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?
  • 7. Ciba: How Much Debt?
  • 8. Ciba: Are Revenues Stable? Ciba Sales and Earnings (in billions of Swiss francs) 1982 1984 1986 1988 1990 1992 0.1 1 10 100 Legend Sales Profits
  • 9. 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
  • 10. 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
  • 11. 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.
  • 12.
    • 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?
  • 13. Currency of Ciba’s Assets and Debt Geographic distribution of Currency distribution of sales Remarks on economic exposure Estimated currency distribution of debt Fixed assets Sales Switzerland 41%  43% 2.4% Net short position because much of production, but little of sales, here 9% U.K.  27% 5.4% Part of sales effectively U.S. dollar denominated 7% Other Europe 34.6% 21% U.S. and Canada 23% 32% 41.3% 54% Latin America 4% 7% 5.3% Most of sales effectively dollar denominated 2% Asia 4% 13% 10.9% Part of sales effectively U.S. dollar denominated 6% Rest of the world 1% 5% Most of sales effectively dollar denominated 1% Geographic distribution of Currency distribution of sales Remarks on economic exposure Estimated currency distribution of debt Fixed assets Sales Switzerland 41%  2.4% Net short position because much of production, but little of sales, here 9% U.K.  27% 5.4% Part of sales effectively U.S. dollar denominated 7% Other Europe 34.6% 21% U.S. and Canada 23% 32% 41.3% 54% Latin America 4% 7% 5.3% Most of sales effectively dollar denominated 2% Asia 4% 13% 10.9% Part of sales effectively U.S. dollar denominated 6% Rest of the world 1% 5% Most of sales effectively dollar denominated 1%
  • 14. 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 .
  • 15. Designing Debt Duration Currency Effect of Inflation Uncertainty about Future Growth Patterns Cyclicality & Other Effects Define Debt Characteristics Duration/ Maturity Currency Mix Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future 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 Start with the Cash Flows on Assets/ Projects Overlay tax preferences Deductibility of cash flows for tax purposes Differences in tax rates across 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 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 Consider Information Asymmetries 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 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 Leases MIPs Surplus Notes Convertibiles Puttable Bonds Rating Sensitive Notes LYONs Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed
  • 16. Designing Debt Duration Currency Effect of Inflation Uncertainty about Future Growth Patterns Cyclicality & Other Effects Define Debt Characteristics Duration/ Maturity Currency Mix Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future 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 Start with the Cash Flows on Assets/ Projects Overlay tax preferences Deductibility of cash flows for tax purposes Differences in tax rates across 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 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 Consider Information Asymmetries 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 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 Leases MIPs Surplus Notes Convertibiles Puttable Bonds Rating Sensitive Notes LYONs Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed
  • 17. Designing Debt Duration Currency Effect of Inflation Uncertainty about Future Growth Patterns Cyclicality & Other Effects Define Debt Characteristics Duration/ Maturity Currency Mix Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future 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 Start with the Cash Flows on Assets/ Projects Overlay tax preferences Deductibility of cash flows for tax purposes Differences in tax rates across 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 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 Consider Information Asymmetries 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 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 Leases MIPs Surplus Notes Convertibiles Puttable Bonds Rating Sensitive Notes LYONs Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed
  • 18. 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?
  • 19. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBT EQUITY TOOLS MEASUREMENT
  • 20. Young and Old Size Maturity Operating Leverage Financial Leverage Operating Leverage Financial Leverage
  • 21. Domestic and Global Size Maturity Operating Leverage Financial Leverage Operating Leverage Financial Leverage
  • 22. Asian Companies: Life-Cycle Financing
  • 23. Asian Companies: Life-Cycle Financing DOMESTIC BANK DEBT DOMESTIC PUBLIC BONDS AND PAPER EURO, FOREIGN, AND GLOBAL BONDS MEDIUM- TERM NOTE AND CP PROGRAMS D E B T
  • 24. Asian Companies: Life-Cycle Financing FAMILY OR STATE OWNERSHIP DOMESTIC BANK DEBT DOMESTIC PUBLIC BONDS AND PAPER EURO, FOREIGN, AND GLOBAL BONDS MEDIUM- TERM NOTE AND CP PROGRAMS D E B T E Q U I T Y DOMESTIC PUBLIC EQUITY LIMITED FOREIGN EQUITY GLOBAL EQUITY
  • 25. 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
  • 26. 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
  • 27. Banpu
  • 28. Corporate Financing Choices: What Kind of Debt for Banpu?
    • Fixed/floating
    • Currency of denomination
    • Maturity or availability
    • Domestic/Euro
    • Straight/convertible
  • 29. Banpu: Capital Structure
  • 30. Banpu: Capital Structure
  • 31. Interest Rate Risk and Financing Choices Prof. Ian Giddy New York University
  • 32. 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
  • 33. IBM’s Interest Rate Exposure
  • 34. Designing Debt Duration Currency Effect of Inflation Uncertainty about Future Growth Patterns Cyclicality & Other Effects Define Debt Characteristics Duration/ Maturity Currency Mix Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future 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 Start with the Cash Flows on Assets/ Projects Overlay tax preferences Deductibility of cash flows for tax purposes Differences in tax rates across 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 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 Consider Information Asymmetries 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 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 Leases MIPs Surplus Notes Convertibiles Puttable Bonds Rating Sensitive Notes LYONs Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed
  • 35. 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.
  • 36. 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.
  • 37. Pepsico Pension
    • 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
    • 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!
  • 38.
    • 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
    Pension Fund, simplified
  • 39. 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.
  • 40. Three Views of Interest Rate Risk Transactions Exposure Portfolio Exposure Economic Exposure
  • 41. Assignment
  • 42. 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?
  • 43. Aero Lloyd
  • 44. 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?
  • 45.  
  • 46.
    • giddyonline.com
  • 47.
    • w w w . g i d d y . o r g
  • 48.  
  • 49. giddyonline.com Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 917-463-7629 [email_address] http://giddy.org