Prof. Ian Giddy New York University SIM/NYU The Job of the CFO Designing Debt 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: 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?

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

Ciba-Geigy

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?

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?

Ciba: How Much Debt?

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

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

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.

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

Currency of Ciba’s Assets and Debt Geographic distribution Geographic distribution of of Estimated Estimated Currency Currency currency currency Fixed Fixed distribution distribution distribution of distribution of assets assets Sales Sales of sales of sales Remarks on economic exposure Remarks on economic exposure 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

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

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?

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

Young and Old Size Maturity Financial Leverage Operating Leverage

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

Asian Companies: Life-Cycle Financing

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

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 FAMILY OR STATE OWNERSHIP E Q U I T Y DOMESTIC PUBLIC EQUITY LIMITED FOREIGN EQUITY GLOBAL EQUITY

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

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

Banpu

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

Banpu: Capital Structure

Conclusion Fixed/floating: Currency: Maturity or availability: 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?

giddyonline.com Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 917-463-7629 ian.giddy@nyu.edu http://giddy.org