Prof. Ian Giddy New York University Designing Debt

Copyright ©1998 Ian H. Giddy Designing Debt 2 First Principles l 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. l Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. l 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.

Copyright ©1998 Ian H. Giddy Designing Debt 3 The Agenda l What determines the optimal mix of debt and equity for a company? l How does altering the mix of debt and equity affect the value of a company? l What is the right kind of debt for a company?

Copyright ©1998 Ian H. Giddy Designing Debt 4 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

Copyright ©1998 Ian H. Giddy Designing Debt 5 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

Copyright ©1998 Ian H. Giddy Designing Debt 6 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

Copyright ©1998 Ian H. Giddy Designing Debt 7 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT INVESTMENT FINANCING RISK MANAGEMENT

Copyright ©1998 Ian H. Giddy Designing Debt 8 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

Copyright ©1998 Ian H. Giddy Designing Debt 9 Corporate Financing Choices: What Kind of Debt? l Fixed/floating l Currency of denomination l Maturity or availability l Domestic/Euro l Public/private l Asset-based l Credit enhanced l Swapped l Equity-linked

Ciba-Geigy: What Kind of Debt?

Copyright ©1998 Ian H. Giddy Designing Debt 11 Short Term or Long Term? l In 1992, Ciba had fixed assets of SF13.9 billion and capital expenditures of SF1.9 billion. l Yet the majority of Ciba's debt is in the short-term commercial paper, bank debt, and suppliers-credit markets. l 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.

Copyright ©1998 Ian H. Giddy Designing Debt 12 l Geographic location of sales and capital assets. l Currency distribution of sales. l Nature of the company's businesses Currency of Denomination of Ciba's Debt? What Should It Be?

Copyright ©1998 Ian H. Giddy Designing Debt 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 Switzerland41%  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% Asia4%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 Switzerland41%  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% Asia4%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%

Copyright ©1998 Ian H. Giddy Designing Debt 14 What Kind of Debt? Some Considerations l Fixed/floating:  How certain are the cash flows? Are operating profits linked to interest rates or inflation? l Currency:  Consider currency of the assets: currency of denomination vs. currency of location vs. currency of determination. l 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?

Copyright ©1998 Ian H. Giddy Designing Debt 15 Guidelines for Financing l Liabilities to match assets: economic exposure of the firm determines base financing choices. l Decision on whether or not to fully match depends on company's view relative to the view implied by market prices. l When strategy is chosen, use the financing/hedging techniques that offer the lowest effective cost.

Copyright ©1998 Ian H. Giddy Designing Debt 16 Designing Debt DurationCurrencyEffect 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

Copyright ©1998 Ian H. Giddy Designing Debt 17 Approaches for Evaluating Asset Cash Flows l 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? l 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 l III. Historical Data  Operating Cash Flows  Firm Value

Copyright ©1998 Ian H. Giddy Designing Debt 18 The Financing Details: Intuitive Approach for Disney

Copyright ©1998 Ian H. Giddy Designing Debt 19 Financing Details: Other Divisions

Debt? Equity? What kind? Debt? Equity? What kind?

Copyright ©1998 Ian H. Giddy Designing Debt 21 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 AssetsLiabilities

Copyright ©1998 Ian H. Giddy Designing Debt 22 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 AssetsLiabilities Debt Residual payments Upside and downside Residual claims Voting control rights Residual payments Upside and downside Residual claims Voting control rights Equity

Copyright ©1998 Ian H. Giddy Designing Debt 23 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 AssetsLiabilities Debt Residual payments Upside and downside Residual claims Voting control rights Residual payments Upside and downside Residual claims Voting control rights Equity What if... Claims are inadequate? Returns are inadequate?

Copyright ©1998 Ian H. Giddy Designing Debt 24 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 AssetsLiabilities Debt Residual payments Upside and downside Residual claims Voting control rights Residual payments Upside and downside Residual claims Voting control rights Equity Alternatives n Collateralized n Asset-securitized n Project financing n Preferred n Warrants n Convertible

Prof. Ian Giddy New York University Hybrid Financial Instruments

Copyright ©1998 Ian H. Giddy Designing Debt 26 Managing Hybrid Securities l Principles of hybrid instruments l Market imperfections as motives for hybrids l Hybrids in the Eurobond market:  Asset-backed securities  Warrant bonds and convertibles  Index-linked bonds l Application: callable bonds

Copyright ©1998 Ian H. Giddy Designing Debt 27 A Day in the Life of the Eurobond Market l Examine the deals  Why were each done in that particular form?  What determines the pricing? l Can you break the hybrids into their component parts?

Copyright ©1998 Ian H. Giddy Designing Debt 28 A Day in the Life...

Copyright ©1998 Ian H. Giddy Designing Debt 29 Equity-Linked Eurobonds l Eurobonds with warrants  Marui l Convertible Eurobonds  Battle Mountaingold l Index-linked Eurobonds  Bank of Montreal

Copyright ©1998 Ian H. Giddy Designing Debt 30 Warrants Theoretical Value Market Value Market Premium V a l u e o f W a r a n t ($) 0 Price Per Share of Common Stock ($)

Copyright ©1998 Ian H. Giddy Designing Debt 31 Convertibles Conversion Value Straight Bond Value Market Value Market Premium V a l u e o f C o n v e r t i b l e B o n d ($) 0 Price Per Share of Common Stock

Copyright ©1998 Ian H. Giddy Designing Debt 32 Nikkei-Linked 28,00019,000 PRINCIPAL REPAYMENT

Copyright ©1998 Ian H. Giddy Designing Debt 33 Economics of Financial Innovation l Certain kinds of market imperfections allow hybrids to flourish l But innovation are readily copied; so only certain kinds of firm can profit from innovations. l There is a product cycle and profitability cycle of innovations.

Copyright ©1998 Ian H. Giddy Designing Debt 34 What Conditions Permit Hybrids to Thrive? l Government Rules and Regulations Example: Japan Air Lines Yen-linked Eurobond l Tax Distortions Example: Money Market Preferred l Constraint on Issuers or Investors Example: Nikkei-Linked Eurobond l Segmentation-Driven Innovation Example: Collateralized Mortgage Obligations (CMOs)

Copyright ©1998 Ian H. Giddy Designing Debt 35 Structured Notes l Bundling and unbundling basic instruments l Exploiting market imperfections (sometimes temporary) l 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.

Copyright ©1998 Ian H. Giddy Designing Debt 36 Medium-Term Notes: Anatomy of a Deal

Copyright ©1998 Ian H. Giddy Designing Debt 37 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-.10  Is not too concerned about specific timing of issue, amount or maturity  Is willing to consider hybrid structures.

Copyright ©1998 Ian H. Giddy Designing Debt 38 Anatomy of a Deal Investor:  Has distinctive preference for high grade investments  Looking for investments that will improve portfolio returns relative to relevant indexes  Invests in both floating rate and fixed rate sterling and dollar securities  Can buy options to hedge portfolio but cannot sell options

Copyright ©1998 Ian H. Giddy Designing Debt 39 Anatomy of a Deal Intermediary:  Has experience and technical and legal background in structure finance  Has active swap and option trading and positioning capabilities  Has clients looking for caps and other forms of interest rate protection.

Copyright ©1998 Ian H. Giddy Designing Debt 40 The Deal 1Initiate medium term note programme for the borrower, allowing for a variety of currencies, maturities and special structures 2Structuring a MTN in such a way as to meet the investor’s needs and constraints 3Line up all potential counterparties and negociate numbers acceptable to all sides 4Upon issuer’s and investor’s approval, place the securities

Copyright ©1998 Ian H. Giddy Designing Debt 41 The Deal / 2 5For the issuer, swap and strip the issue into the form of funding that he requires 6Offer a degree of liquidity to the issuer by standing willing to buy back the securities at a later date.

Copyright ©1998 Ian H. Giddy Designing Debt 42 The Issue l Issuer: Deutsche Bank AG l Amount: US$ 40 Million l Coupon: First three years: semi-annual LIBOR + 3/8% p.a., paid semi-annually Last 5 years: 8.35% l Price: 100 l Maturity: February 10, 2000 l Call: Issuer may redeem the notes in full at par on February 10, 1995 l Fees: 30 bp l Arranger: Credit Swiss First Boston

Copyright ©1998 Ian H. Giddy Designing Debt 43 The Parties in the Deal SCOTTISH LIFE CSFB DEUTSCHE

Copyright ©1998 Ian H. Giddy Designing Debt 44 The Deal in Detail SCOTTISH LIFE CSFB DEUTSCHE Deutsche sells 3-year floating rate note paying LIBOR - 3/8%

Copyright ©1998 Ian H. Giddy Designing Debt 45 The Deal in Detail SCOTTISH LIFE CSFB DEUTSCHE Deutsche sells 3-year floating rate note paying LIBOR - 3/8% For an additional 3/4% p.a., Deutsche buys three- year put option on 5-year fixed-rate 8.35% note to SL in 3 years

Copyright ©1998 Ian H. Giddy Designing Debt 46 The Deal in Detail SCOTTISH LIFE CSFB DEUTSCHE Deutsche sells 3-year floating rate note paying LIBOR - 3/8% For an additional 3/4% p.a., Deutsche buys three- year put option on 5-year fixed-rate 8.35% note to SL in 3 years For 1% p.a., Deutsche sells CSFB a swaption (the right to pay fixed 8.35% for 5 years in 3 years)

Copyright ©1998 Ian H. Giddy Designing Debt 47 The Deal in Detail SCOTTISH LIFE CSFB DEUTSCHE Deutsche sells 3-year floating rate note paying LIBOR - 3/8% For an additional 3/4% p.a., Deutsche buys three- year put option on 5-year fixed-rate 8.35% note to SL in 3 years For 1% p.a., Deutsche sells CSFB a swaption (the right to pay fixed 8.35% for 5 years in 3 years) CLIENT CSFB sells the swaption to a corporate client seeking to hedge its funding cost against a rate rise

Copyright ©1998 Ian H. Giddy Designing Debt 48 What’s Really Going On? Note: l 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 l 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.

Copyright ©1998 Ian H. Giddy Designing Debt 49 Motivations for Issuing Hybrid Bonds l Company has a view l There are constraints on what the company can issue l The company can arbitrage to save money l Always ask: given my goal, is there an alternative way of achieving the same effect (e.g., using derivatives?)

Copyright ©1998 Ian H. Giddy Designing Debt 50 First Principles Again l 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. l Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. l 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.

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Copyright ©1998 Ian H. Giddy Designing Debt 54 Ian Giddy NYU Stern School of Business Tel ; Fax